Morningstar makes bid to offer mutual funds for exclusive use of advisers

The research firm wants to launch sub-advised in-house funds with lower investor fees that financial planners can throw into managed account portfolios to pass on the savings to clients, according to an SEC filing

Mar 10, 2017 @ 2:35 pm

By Jeff Benjamin

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Morningstar Inc. has filed with the Securities and Exchange Commission to launch nine mutual funds for use in its managed portfolios that are specifically for financial advisers.

The March 6 filing explains that the move is designed to generate cost savings that will be passed down to the investor level by replacing the third-party mutual funds currently used in Morningstar Managed Portfolios.

However, some observers are already raising red flags at the notion of the fund-tracking company getting into the mutual fund business.

"This is a surprise and it looks like a bad idea," said Stephen Janachowski, chief executive of the financial advisory firm Brouwer & Janachowski.

"Morningstar is seen as an objective reviewer of investment products and funds, and this looks like they are getting into becoming a money manager," he added. "It might seem like a natural move for them, but anytime you're doing the same thing you're evaluating other people doing, it's blurring the lines."

A Morningstar spokeswoman declined to comment for this story, citing the quiet-period restrictions while the filing is being reviewed by the Securities and Exchange Commission.

According to the filing, the new funds will be managed by subadvisors which will be selected by Morningstar, similar to the way mutual funds are now selected for the 17-year-old managed account platform.

Replacing outside mutual funds with subadvised in-house funds is expected to result in a 20% net reduction in investor fees, according to the filing.

Other reasons cited for launching the funds are flexibility and simplicity.

Currently, the managed portfolios include between 15 and 25 third-party mutual funds.

Because the Morningstar funds will each use multiple subadvisors, the filing states, "we believe we can use about one-quarter to one-third as many funds while keeping the same investment exposures. This should make the portfolios easier for advisers and clients to understand, and should also simplify portfolio management itself."

Jeffrey Seglin, director of the communications program at Harvard Kennedy School, said Morningstar might be treading into dangerous territory by launching its own funds, regardless of the rationale.

"They need to be as rigorous and transparent as possible," he said. "And the cost-savings part is a claim a lot of fund companies make, but the proof will be in the pudding."

According to the filing, Morningstar will not be initially assigning forward-looking analysts' ratings to the funds, which are more subjective than the more-popular and backward-looking star ratings.

It is not clear if the funds will be eligible to earn star ratings, but that could represent a conflict of interest, according to Todd Rosenbluth, director of mutual fund and ETF research at CFRA.

"What they're doing makes sense in that they are trying to build lower cost products for advisers, but because of who Morningstar is in the fund world, it makes what they're doing more challenging," he said. "There are all kinds of potential conflicts here."

Citing the tendency of both financial advisers and individual investors to favor funds with better star ratings, Mr. Rosenbluth said Morningstar could end up in an awkward position.

"Three years after the launch, these funds will be eligible for star ratings just like the rest of the funds in the universe, and if they do well that could create a conflict," he said. "And if they don't do well it raises the question of whether they really are a viable alternative to what they had before."

While the star ratings are based on quantitative investment performance, Mr. Rosenbluth pointed out that Morningstar still decides the categories in which the funds are placed, which can make a difference in how a fund is ranked and rated.

"Morningstar is trying to capitalize on their brand, but in doing so they are also shining a spotlight on their objectivity," Mr. Rosenbluth said. "It's easy to say its better because it's for financial advisers and not direct retail, but we all know that advisers are using star ratings for fund selection and to justify the fund selection to their clients."

The Morningstar funds, which are not expected to be launched before October, include U.S. equity, international equity, global income, total return bond, defensive bond, multi-sector bond, municipal bond, unconstrained allocation, and alternatives.

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