Morningstar slams some liquid alternative funds for masking actual expense ratios

The funds take advantage of the SEC's reporting rules on derivatives to make their high fees look smaller than they actually are.

Liquid alternative funds have a reputation for being expensive and ineffectual, which defenders say is unjustified. According to Morningstar, however, a few funds use a loophole to make those high fees seem reasonable.

A few managed futures funds and multialternative funds — those that incorporate several alternative strategies, such as commodities, long and short positions and convertible arbitrage — take advantage of the Securities and Exchange Commission’s reporting rules on derivatives to make their expense ratios look smaller than they actually are, said Morningstar analyst Jason Kephart.

Some funds are using total return swaps rather than hiring subadvisers or investing directly in a hedge fund, Mr. Kephart said. A total return swap is an agreement where the fund makes a fixed payment and gets an amount equal to the total return from an index or other investment, such as a hedge fund.

Funds have to include a subadviser’s fee in its expense ratio. By using the swap, the fund can relegate its cost to a footnote (or simply a holding) and remove it from the expense ratio, Mr. Kephart said. And even then, the fund can simply report a range of potential costs.

The move can drop an expense ratio from 3% to 1.75% or less. “I can see how they would not want to advertise how big the fees actually are,” Mr. Kephart said.

For example, Morningstar called out GMG Defensive Beta fund (MPDAX) as particularly opaque. The fund lists a 22% stake in GMG Fund Unlimited, which the fund says allows it access to eight subadvisers, but doesn’t name them or how they are compensated, Mr. Kephart said.

Oliver Pursche, co-manager of the fund, said that its strategy with the GMG fund began being implemented in April and wasn’t fully put into place until June. The fund has written a new prospectus, dated August 1, which is awaiting SEC approval. The fund’s website is down until the new prospectus can be published.

“Expenses on the fund are capped at 1.49%; we made no attempt to hide anything,” Mr. Pursche said.

Other funds are starting to move towards greater disclosure. LoCorr Managed Futures Strategy I (LFMIX), for example, moved from using swaps to subadvisers, Morningstar said, reducing ownership costs to 1.81% from more than 3%. LoCorr Long/Short Commodity Strategies (LCSAX) and LoCorr Multi-Strategy (LMUAX), however, still use total return swaps.

Morningstar complained to the SEC about swap disclosure in an August 2015 letter. “In recent years, funds offering ‘liquid alternative’ strategies have more frequently held swaps linked to the return of a commodity pool, or a private index…if there are costs associated with the management of the CFC or expenses embedded in the return being received (in the case of swaps on the return of commodity pools), these expenses should be footnoted in the financial statements and reported either in calculations of total operating expenses or as acquired fund expenses in other filings.”

“We’re hopeful the SEC will do something,” Mr. Kephart said.

The SEC currently has no new rules proposed for derivative disclosure, and any new rules would require a public comment period. But it could issue guidance for alternative funds to make sure that footnoted disclosures were done uniformly.

The SEC was not immediately available for comment.