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The People Pillar

A closer look at the new forward-looking Morningstar Analyst Ratings for alternative mutual funds.

Nadia Papagiannis, CFA, 10/17/2012

Morningstar has come a long way since the original Morningstar Rating. Introduced in 1985, the 5-star rating system was designed to quantitatively rank funds on past risk-adjusted performance relative to their peers, on a three-, five-, and 10-year basis. While the Morningstar Ratings are still alive and well, and have shown to be somewhat predictive over time, they paint an incomplete picture for investors attempting to pick the future winners. What happens to a fund if a manager leaves or if the investment process changes, for example? It's clear that factors other than past performance matter. 

Our forward-looking ratings analyze funds against their peers in five areas, or "pillars": People, Parent, Process, Performance, and Price. Each pillar is rated Negative, Neutral, or Positive. The goal is to find the funds in each category that will outperform relative to their category peers over the next three or more years. We use the same five pillars to rate alternative mutual funds and traditional funds alike, but alternative funds require a unique spin. Here's a deeper dive into our “People” pillar.

Power to the People
Our People pillar measures our confidence in a fund's management team. If the current manager has directed the fund and similar strategies for a long time, with success, we have more confidence in that manager going forward. The problem with alternative funds is that they are virtually brand new--almost 60% of the 340 distinct funds in Morningstar's seven alternative categories were launched after 2008. So, it's hard to have confidence in those managers--at least regarding their experience running mutual funds. But for alternative funds, many of these managers have run similar strategies in hedge funds or separate accounts. To the extent managers disclose their past performance in other vehicles, we take this experience into account. (Morningstar has one of the largest hedge fund databases in the industry, with almost 7,500 funds.)

When we assess an alternative manager's experience, we are assessing his or her experience shorting and managing risk. These skills are not particularly a concern for traditional mutual funds, which are often required to be fully invested and tied to a strict benchmark. In contrast, alternative mutual funds have the ability to significantly vary in market risk exposure, and widely accepted benchmarks do not exist for alternative strategies. Besides experience with shorting and risk management, though, another factor that concerns alternative funds more than many traditional funds is key-man risk. Because many alternative funds are advised by boutique firms, the decision-making can often come from one person. Take Merk Hard Currency MERKX, a short-U.S. dollar fund run by Axel Merk. Although Merk has worked hard to establish a repeatable investment process, he often calls the shots.

Finally, if a manager is heavily invested in his or her own fund, we typically have more confidence in its future performance. Skin in the game aligns the managers' interests with shareholders'. In traditional stock and bond mutual funds, it's not uncommon to find a manager with more than $1 million invested in his or her own products. With alternative products, a large investment in one particular strategy is not always prudent. Take market-neutral equity strategies, for example. These funds hope to earn a couple of percentage points above cash in virtually every market environment. With near-zero interest rates, a manager may not want to allocate his or her life savings to such a low-return strategy. Nevertheless, there are managers in almost every alternative category with $1 million or more invested in their funds (Evan Dick of Highbridge Statistical Market Neutral HSKAX, for example). We tend to give these managers higher People ratings.

See Table 1 for a list of the 47 alternative mutual funds we have rated, and their respective “People Pillar” ratings.

 

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Nadia Papagiannis is an analyst with Morningstar.
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