Jeffrey Gundlach’s Blood Feud With Morningstar: The Inside Story

Is the genius of DoubleLine founder Jeffrey Gundlach on display resulting from his recent disagreement of opinion with Morningstar, Inc. (NASDAQ:MORN)? And what exactly is the special sauce behind DoubleLine’s rather dramatic out-performance relative to industry benchmarks?

As DoubleLine today announces total firm net inflows of $688.7 million in July, with the flagship DoubleLine Total Return Bond Fund (DBTLX) snatching as much as $390.4 million in new assets alone, the firm founded in the wake of an employee dispute has garnered strong net asset inflows since the issue with Morningstar first surfaced — a time period correlated with the exit of Bill Gross from PIMCO, which was also a factor.

The often subtle and sometimes public disagreement between Gundlach and Morningstar – Barron’s at one point categorized it a “Blood Feud” in a headline – was on display in a June webcast to financial advisors and investors. In the webcast to his generally devoted flock of financial advisors and investors, Gundlach appeared to point to Morningstar without mentioning their name, saying “weak analysts” did not understand his portfolio construction. Then on July 14, just days before Morningstar was to release its review of DoubleLine, the Wall Street Journal ran a story that led with the hyperbolic descriptor proclaiming Gundlach was “locked in a protracted staredown with an unlikely foe: Morningstar Inc.”

Shortly thereafter Morningstar released a kinder, gentler version of its DoubleLine review, never saying anything negative, as in the past, but rather observing that DoubleLine did not provide required transparency into their risk management and thus could not be rated for the second year in a row. DBTLX still enjoys Morningstar’s five star “piller” risk-adjusted performance ratings, but remains “Not Ratable” under its Morningstar Analyst Rating methodology. The transparency issues were still a notable sore point despite an outwardly polite tone that forced Morningstar’s hand to determine that DoubleLine could not be properly reviewed. Thus two of the highest profile industry players extended a disagreement that appears to have started even before DoubleLine had been founded.

Some involved in the situation say they are not in a “feud” and downplay the “dispute,” hoping that it would fade like a mellow Pacific Ocean sunset. Observers, however, doubt either side will move off their rather hardened positions in what appears now like a polite disagreement with a somewhat sharp-edged history.

In analyzing DoubleLine, however, does all the gamesmanship miss the point? Does Gundlach have a point when he says Morningstar doesn’t understand his portfolio construction? Does DoubleLine’s noncorrelated portfolio management techniques, reviewed for the first time in this article, begin to uncover the real genius behind industry beating returns?

On the other side of the dispute, sticking to its ratings principles is Morningstar. Are they doing exactly what should have been done in 2008 when what at first appeared like brilliantly profitable in mortgage-related securities were later revealed to be a non-transparent investment product that obfuscated toxic assets?

In 2008, the ratings agencies didn’t accurately warn investors about the true risk involved in the mortgage investment products at the center of the 2008 financial crisis simply because they did not know that which they were rating. Had those who rated the toxic bond products with AAA ratings really known that below investment grade credit profiles populated a large percentage of the fund – had they demanded transparency as Morningstar is now doing – perhaps the 2008 financial crisis might have been avoided to some degree.

Morningstar is not a National Recognized Statistical Organization (NRSO) as are the ratings agencies that evaluated the mortgage backed securities in 2008 and did not demand transparency. But does not providing Morningstar transparency matter to DoubleLine’s loyal investor base? The answer is apparently not. Since July 16, 2014 when Morningstar most recently changed their fund rating from neutral to not ratable, investor inflows have increased the fund’s assets under management to $47.2 billion as of today.

Is Gundlach a genius?

DoubleLine has 15 different investing strategies all with various risk profiles and product types. The primary focus is on bonds, but the firm also offers higher risk profile products with equity, commodity and even alternative investment exposure.

Looking at nothing but the headline performance of the DoubleLine’s largest offering, the Intermediate-Term Bond fund (DBTLX), strictly on a statistical basis, those higher than average returns and lower risk measures numbers speak for themselves. Lower standard deviation (volatility) than the benchmark and category average, much higher Sharpe Ratio and upside returns capture percentages. Investing in lower bond duration periods one might assume lowered interest rates and returns, but not so with DoubleLine. The firm delivered solid performance during good and bad times, including the difficult 2013 period, when most intermediate bond funds lost money.

DoubleLine’s performance statistics, which are analyzed further in tomorrow’s article, appear as genius, but what about the man behind the portfolio?

Listening to DoubleLine’s June public webcast, Jeffrey Gundlach, the firm’s founder, a man who is now being praised as the “bond king” by some journalists, it is evident why such thoughts persist.  Having been awarded the “king” crown without a vote or even democratic discussion, nonetheless the mantle formerly held by Bill Gross appears to look fitting on Gundlach’s head at the moment.

Time and time again in the webcast Gundlach pointed to accurate past calls as well as providing insight into future probability paths with what appears to be strong if somewhat nontraditional insight. Regarding the U.S. government debt issue to which select quantitative and discretionary hedge fund managers are aware, Gundlach notes the forthcoming “demographic problem” and says that debt crises typically take a longer time to develop than generally assumed, and then, after muddling through, the market action moves rather rapidly. In other words, Gundlach thinks apart from the crowd not just on macro issues, but as you will see he appears to view conservative bond investing with a “traders edge attitude,” yet the DBTLX portfolio performance statistics remain generally conservative and DBTLX invests in generally high quality bonds.

The vast majority of the DBLTX portfolio, 70.4 percent as of June 30, is investment grade and 57.4 percent of the portfolio is guaranteed by the U.S. government and another 6.1 percent is in cash. Only 18 percent of the fund’s bond holdings are below BBB-, and only 5.2 percent were unrated. Investments with a higher risk profile, it should be noted, are only one sleeve in the entire portfolio. “Here’s the mix of DBLTX sector-wise,” Gundlach explained in the webcast. “It’s all Treasuries or securitized assets: agency pass-throughs, 29%; agency CMOs, 23%; non-agency RMBS, 23%; 8% in CMBS; and 5% in collateralized loan obligations, which are backed by bank loans; 4% in Treasuries; and we’re now only 7% in cash, having been as high as 23% cash at the worst part of the market in July of 2012 to help principal protect.”

While Gundlach is interested in the total effects of all portfolio components, listening to him talk, it appears as though what he personally finds interesting are the risky components of the portfolio; he looks like he is fascinated by diving off cliffs into carefully measured water where mainstream investors are scared, sifting through investment rubble to find overlooked gems in DBTLX and other fund offerings. While DBTLX mostly invests in bonds at an average of 99 cents on the dollar, in his web cast he focused on the investments where value opportunities presented themselves. Not all of these CCC rated bond investments he purchases at 40 cents on the dollar work exactly as planned. DoubleLine addresses this through a sophisticated risk management philosophy that translates into recognizing that certain risk, when extended over mathematical levels of standard deviation magnitude, have a natural backstop at zero and that emotional selling decisions based on what appears like “toxic” assets can create value dispersion opportunities. In part, the genius, which Gundlach  discusses, is how the wide variety of credit exposure is noncorrelated and actually negatively correlated to various degrees. The noncorrelated aspect of DoubleLine is just one area in which they shine, but it is a component of their portfolio management philosophy that has yet to be publicly explored from this angle and, in part, explains the firm’s dramatic out-performance with such low volatility – a trademark of a truly diversified investment.

This all fits in to a narrative where an independent and respected firm rating DoubleLine is questioning the man some acknowledge as “king” in a traditionally conservative and somewhat sleepy bond investing category.

Morningstar asks key questions

DoubleLine, it should be noted, has been reviewed by a variety of high quality industry players who have conducted what was described as rigorous due diligence. S&P Capital IQ has afforded DBTLX top ratings after extensive interviews with DoubleLine CEO and Chief Investment Officer Jeffrey Gundlach, DoubleLine President Philip Barach, DoubleLine director of Global Developed Credit Bonnie Baha, and DoubleLine Emerging Markets Fixed Income  Director Luz Padilla. Altegris managed futures strategy uses DoubleLine as a sub-advisor, State Street Global Advisors and Litman Gregory have both given the fund strong reviews in their asset allocation decisions, and Risk Magazine named DoubleLine Capital its Asset Manager of the Year in 2015.

So what is different about Morningstar?

Stay tuned for Part II