Reading between the lines of liquid alternatives fund expense ratios

As more financial advisers wade into alternative strategy mutual funds, many are discovering the unique riddle of variable — and often confusing — expense ratios for certain strategies.
For example, Morningstar Inc. lists an expense ratio of just 25 basis points for the $361 million Vanguard Market Neutral Fund (VMNFX). But on its website, The Vanguard Group Inc. lists the fund’s expense ratio at 1.6% — more than six times as high as Morningstar’s calculation.
Likewise, Morningstar pegs the expense ratio of the $700 million JPMorgan Research Market Neutral Fund (JPMNX) at 99 basis points, while J.P. Morgan Asset Management reports it as 3.35%.
And nothing drives the point home like the $720 million TFS Market Neutral Fund (TFSMX), which Morningstar says charges 2.02% but TFS Capital reports as 8.4%.

The wacky world of expense ratios

“I’m shocked, to be honest, and I’d like to know what the real freaking number is,” said Thomas Meyer, chief executive of Meyer Capital Group.
In the most basic sense, the expense ratio Morningstar lists is what fund companies charge investors to manage the fund; the larger expense ratio listed on fund company websites and detailed in prospectuses reflects the costs of short selling and leverage inside the fund.
The wide variation is primarily concentrated in liquid-alternatives funds because the Securities and Exchange Commission requires them to show the added internal costs of short selling and leverage.
“There is a difference between what the fund company is charging you and what the fund costs are, and with liquid alternatives, the fee story gets more complicated,” said Russell Kinnel, director of mutual fund research at Morningstar.
Part of the cost of short selling, which involves borrowing stock to be sold with the aim of buying it back later at a lower price, is the dividend yield the short seller must pay the original owner of the stock.
And because higher-yielding dividend stocks are considered among the most overvalued in the current market, their appeal as short-selling targets is driving up the cost of managing long-short and market-neutral funds.
“Our expense ratio will change over time, depending on whether we’re shorting high- or low-dividend stocks,” said Lee Norton, senior investment analyst at Vanguard. “I think of it as a trading cost that the SEC requires us to disclose. But that 1.6% expense ratio is prominently displayed on our website.”
The Vanguard Market Neutral Fund is down 0.52% since the start of the year, a little steeper than the 0.3% decline in the S&P 500 Index, and the 0.4% decline in the Morningstar market neutral category.
Beyond the dividend expense, there is a borrowing cost related to short selling that will vary depending on the type of stock being shorted.
In the case of the TFS Capital fund, for example, the strategy’s focus on shorting smaller companies represents more than 5 percentage points of annualized cost in managing the fund, while the dividend cost adds another percentage point or so, according to Sam Harris, the firm’s director of client relations.
“We found that our models add the most alpha in the small-cap space and we have a bigger concentration in the small caps, which are more expensive to borrow because there’s less supply,” Mr. Harris said. “We tell investors we’re choosing to incur that cost because that’s where we see the opportunities, and we could reduce it by shorting large-cap names, but we’re paying that expense because we think it is well worth it.”
Indeed. So far this year, the TFS fund is up 1.3%.

Source: Morningstar, Inc.

Note: Through Feb. 2015

As with all mutual funds, the reported performance is net of all fees, but that doesn’t mean the full picture of expense ratios should be ignored by financial advisers and investors, because much can be gleaned from how wide the fee variation is for a particular fund.
Even if performance is net of fees, the cost of shorting stocks should be factored in as an internal cost of running a strategy that could result in a potential drag on performance.
Most fund companies don’t like having to break out the added costs, and some compare it to the brokerage costs inside traditional funds. The main problem with that argument is that alternative funds also have brokerage costs, which are not detailed for investors to see.
“Unfortunately, this is the problem with liquid alternatives, and you’ve got to roll up your sleeves and dig into it,” Mr. Meyer said. “A lot of advisers don’t have the time or the gumption to get that done.”
But for any adviser allocating client assets to liquid-alts funds, the extra research into expense ratios is time well spent.

Related Topics: Alternatives, For Your Practice, Morningstar Inc., Topical Microsites, Vanguard Group