Doubleline Total Return Bond Fund (DBLTX and DLTNX), the flagship fund of bond ace Jeffrey Gundlach’s new investment shop, now has a three-year existence, which means Morningstar has applied its famous mathematically-based star rating to it. To nobody’s surprise, the fund has earned a 5-star rating, meaning it lands in the top 10% of its category for risk-adjusted performance over its initial three-year period. Risk is counted as volatility or standard deviation of returns in the Morningstar formula.
In Doubleline Total Return’s case, the category is the “intermediate bond category,” which contains funds generally benchmarked against the main bond index, the BarCap US Aggregate Bond Index, and serve as core holdings or workhorses of most investors’ bond portfolios. If you’re a retiree seeking income from your capital, this is a category of mutual funds that will contain candidates, such as Doubleline Total Return, for a significant chunk of your assets.
Morningstar provides the mathematical details of the star rating in this methodology paper.
There are actually 3 different star ratings for funds that have been around long enough to receive them – a 3-year rating, a 5-year rating, and a 10-year rating. Unfortunately, for funds that have all three, the three ratings are simply averaged to arrive at a final star rating without the longer term ratings garnering more weight in the calculation. Still, despite its imperfections, the process is reasonable and has generally helped investors and advisors who know enough to use the star rating as a starting point, not as the last word, in their fund analyses. It’s also worth noting that Gundlach’s prior charge, TCW Total Return, perennially carried a 5-star rating.
Now, Morningstar’s business isn’t simply applying a mathematical formula to measure risk- or volatility-adjusted returns of mutual funds. Of course, the Chicago-based ratings firm is also famous for its often helpfully opinionated writeups of funds that complement and sometimes are at odds with the star rating. Although it becomes more difficult to argue against a fund with a high star rating and for a fund with a low star rating if the funds have long track records, analysts at the firm aren’t shy about overriding the rating on funds it views as short-term wonders or as the victims of unusually unfortunate short-term circumstances in fund writeups. “This fund isn’t as good as it looks” or “this fund is better than it looks” are common tenors of analyses, and there are good reasons for that. Over short periods of time good investors can look worse than they are, and bad investors can look better than they are.
This is also why Morningstar applies a “qualitative” rating to funds that’s independent of the star rating. The qualitative rating consists of process, performance, people, parent, and price pillars. On these more nebulous metrics Doubleline Total Return scores decidedly less well than its star rating. While it garners positive grades for performance (how could it not?), people, and price, it achieves negative grades on parent and process. Overall, the two negative grades on parent and process give the fund a neutral qualitative rating instead of one of Morningstar’s favored bronze, silver, or gold ratings.
First of all, the difference between people and parent is almost ridiculous in the case of Doubleline because the people and the parent are identical. Many asset management teams serve as subadvisors for funds issued by other parents in the mutual fund industry — Doubleline included — but Gundlach and team are completley responsible for the Total Return Strategy. It seems impossible to favor the people and dislike the parent in this case. The distinction between parent and people seems bogus for this fund.
Second, regarding process, the additional negative grade the fund receives, it is inconceievable that Morningstar analysts are equipped to judge how Gundlach and his team evaluate complex mortgage (both agency and non-agency) securities, including interest-only principle-only, and inverse-floating securities. I am no bond expert, and I don’t envy someone trying to evaluate these complex things; the job of understanding Gundlach’s portfolio’s is undoubtedly fraught with difficulty for a fixed income novice — and probably even someone who’s not a novice. This blog post shows that Morningstar is likely not up to the task.
The bond market is “The Wild West” of the investment world, as Michael Lewis hs written, and it’s not easy for even very bright people to make sense of it (especially the mortgage sector) in short order. Nevertheless, the proof of such good long-term performance should give Gundlach and his team the benefit of the doubt in their ability to navigate the mortgage market. If the portfolio is beyond most people’s comprehension, the performance isn’t, including in 2008, when Gundlach eked out a positive gain at TCW Total Return with a mortgage portfolio.
Clearly Morningstar is concerned with the non-agency (non-government guaranteed) mortgages Gundlach has made excellent use of in the aftermath of the financial crisis. But Morningstar seems to be assuming that these are new positions for Gundlach, while the truth is he held them near the end of his tenure at TCW in 2009, when the market began coughing them up at bargain prices and when Morningstar nominated Gundlach for its Fixed Income Manager of the Year Award. It’s true that for most of Gundlach’s tenure at TCW, he held higher quality mortgages, but most of that tenure wasn’t marked by a financial crisis. Morningstar analysts seem to be forgetting that when good prices appeared, Gundlach pounced on non-agency mortgage-backed bonds even before he left TCW. They also seem to be forgetting that Gundlach made use of all forms of agency morgtage-backed securities, incluing IOs, POs, and CMOs long before he left TCW. Somehow, Morningstar analysts claim that Gundlach has changed his stripes, and is perhaps even recklessly gunning for yield, rather than remembering their own analyses of TCW Total Return in 2009 and concluding that the market has offered unusual securities to him at prices that represent a good margin of safety after the crisis.
The performance of TCW Total Return in 2008 and the fact that Doubleline Total Return has not suffered an adverse event in rising rate periods, falling rate periods, and changes in prepayment rates since its inception might give Morningstar analysts pause about their current posture on the fund. Indeed Doubline Total Return’s standard deviation for the 3-year period is 2.57, only slightly higher than the 2.42 of the BarCap Agg Bond Index.
What’s also troublesome about this is that some of the finest equity managers Morningstar covers — and gives strong qualitative assessments to — dabble in distressed debt when they think prices warrant it. For example, Steve Romick at FPA Crescent, the team at Mutual Series (even long after Michael Price’s departure in the late 1990s), Third Avenue Value, and others are given kudos for going the extra mile in uncovering underpriced oddball securities. It’s not clear why Gundlach doesn’t receive the same kudos.
Full Disclosure: This blog post in no way constitutes investment advice to anyone. I own Doubleline Total Return personally and for clients whom I formally advise.