Awash in alt fund launches, Morningstar examines coverage standards

Analysts may have to examine less than three years' performance

Apr 3, 2014 @ 12:41 pm

By Trevor Hunnicutt

Advisers aren't the only ones struggling to make heads or tails of the market for “liquid alts.” Morningstar Inc. is grappling with how to deal with a deluge of the highly popular alternative mutual funds.

“It's a challenge on a number of levels … we have a certain, defined amount of alternative funds that we have the resources to cover right now,” said Josh Charlson, who recently took over alternative funds research for the firm.

“Historically, at Morningstar, we wouldn't cover a fund until we've had at least a three-year track record,” he said. “We don't really have that luxury, in a certain sense, in the alternatives space because most of them don't have three-year track records in the regulated fund space, so we have to be cautious.”

Many of the liquid alternatives strategies have been adapted from existing hedge funds for the regulatory requirements and marketplace for mutual funds. But it can be difficult to judge managers for their performance under those different investment structures.

Mr. Charlson said the firm is going to try to look at older performance records where they are comparable and will look at funds with fewer years of performance than would otherwise be typical if the fund gathers significant assets or is otherwise notable.

“My goal is for us not to just cover the funds that are being distributed by big fund companies with big distribution machines but also for us to be able to identify managers who may have that institutional pedigree, but don't have the retail pedigree and are also deserving of investors' attention,” he said.

Morningstar spokeswoman Nadine Youssef said the firm is not changing the requirements for its “star rating,” but that its guidelines for selecting what funds to cover with an “analyst rating” could be “slightly different … because they are often younger and smaller funds.”

“We're not relaxing or changing any standards, but our considerations are different for this category of funds,” she said. “As the alternatives space has grown over the past few years, our analysts have covered funds they think are important to investors — this isn't new.”

Morningstar, along with the industry, defines alternatives broadly, looking at funds that use non-traditional strategies in traditional asset classes (such as with futures or options), illiquid investments and other investments beyond bonds and stocks.

There was nearly $162 billion in assets in 429 alternative mutual funds at the end of February, up from nearly 40% in assets in 383 funds a year before, according to Morningstar. The products offer access to hedge-fund style portfolio management strategies, often engineered to limit volatility or investment risk factors while delivering competitive returns.

The products come with their own set of risks, a steep learning curve and, often, a plumper management fee than fund investors may prefer.

“We consider a lot of the funds expensive now,” said Mr. Charlson, speaking Thursday on a panel organized by Fidelity Investments. “As companies get scale and competitiveness increases, the expenses are going to go down.”

Another challenge for Morningstar and advisers is benchmarking the strategies, some of which aim for certain outcomes in terms of volatility. Those funds could be judged against competitors, other hedge funds, their own standards or risk metrics. Mr. Charlson said advisers will probably have to use multiple measures.

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