Jeff Benjamin

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Morningstar doubles down on expense ratio disparity debate

Fund tracker is at odds with SEC on how some fund report expenses

May 26, 2015 @ 12:54 pm

By Jeff Benjamin

The puzzling riddle of expense ratios for many liquid alternative mutual funds is not going away, as illustrated by last week's detailed post by Josh Charlson, director of manager research for alternative strategies at Morningstar Inc.

For financial advisers, trying to answer the riddle often means another layer of research on certain liquid alt strategies, or potentially screening out funds that might otherwise make the cut.

At issue are some glaring discrepancies between fund expense ratios reported by Morningstar and those listed on fund company websites and in prospectuses.

One of the best examples of how advisers and investors can be misled or confused by what it actually cost to run a particular strategy can be found in the $377 million Vanguard Market Neutral Fund (VMNFX).

Morningstar lists the fund's expense ratio at a mere 25 basis points, but The Vanguard Group Inc.'s website lists the same fund's expense ratio at 1.6%. That's still relatively low for an alternative-strategy mutual fund, but more than six times higher than Morningstar's calculation.

Another extreme example is the $747 million TFS Market Neutral Fund (TFSMX), which Morningstar reports having an expense ratio of 2.02%, while the fund company reports it at 8.4%.

“It's sort of a complicated story, and some people think we don't do it the right way,” Mr. Charlson said.

The discrepancy boils down to the Securities and Exchange Commission requirement that funds include the internal cost of short-selling and leverage in calculating their expense ratios. That differs from Morningstar's internal policy of netting out those expenses as part of the cost of doing business, similar to the brokerage costs incurred by virtually every mutual fund.

'PART OF THE INVESTMENT PROCESS'

“Our perspective is that short-selling is part of the investment process,” Mr. Charlson added. “I guess I could see a case for listing the gross expense ratio alongside the net expense ratio for all funds, because there's a benefit in understanding that there are additional costs that are part of the investment process, and engaging in some of these more complex investment strategies do come with additional costs.”

It remains to be seen whether introducing gross and net expense ratios would reduce or increase confusion around fund expenses, but it doesn't really matter because it isn't yet under any real consideration.

It could be argued that Morningstar is thumbing its nose at the SEC for adopting its own method of reporting expense ratios, but the SEC did not respond to a request for comment on whether or not they are even paying attention to the expense-ratio reporting disparities.

Those operating in the fast-growing liquid alts space, however, are paying attention.

“I think a lot of the alternative mutual funds are being penalized by having to report the higher expense ratios,” said Bradley Alford, chief investment officer at Alpha Capital Management, which runs two funds of liquid alt mutual funds.

As he sees it, by having to report expense ratios that include the cost of short-selling, a lot of liquid alt strategies are listing artificially inflated expenses. While he appreciates that Morningstar sees it the same way, Mr. Alford isn't holding his breath waiting for the SEC to change its reporting policy.

“I think Morningstar is seeing the expense ratio requirement as funds being penalized for employing the strategies they're being paid to do, and they've decided to not follow the same way the SEC does it,” he said. “It's a very antiquated rule and it needs to be revised, because it's a changing world now and there are more than 500 alternative mutual funds.”

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