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The Parent Pillar

A closer look at the new forward-looking analyst ratings for alternative mutual funds.

Nadia Papagiannis, CFA, 10/24/2012

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 Parent pillar.

Parent
This pillar measures the quality of the fund's advisor and board of directors. Again, we are looking for an alignment of interests between the fund shareholders and the people who control the destiny of a fund. In terms of an advisor, we tend to favor shops in good regulatory standing whose employees are compensated based upon the performance of the funds they manage, rather than the firm's revenue or assets under management. We also like when firms encourage managers to invest in their own funds. In addition, we prefer fund companies that carefully determine their product lineup and launch funds that represent their core strengths rather than the strategy du jour. These characteristics can be found in any type of mutual fund, traditional or alternative. One example of a standout alternative advisor/fund company is TFS capital, which manages TFS Market Neutral TFSMX and TFS Hedged Futures TFSHX. This 100% employee-owned firm requires its principals to invest 50% of their liquid net worth in the funds.

An independent, qualified, and vested board of trustees is also the mark of a good parent. The trustees are responsible for keeping fees low and for closing funds nearing capacity, two factors that affect a fund's performance. Alternative funds' "parent" considerations may differ from traditional mutual funds in that many alternative mutual funds are part of series trusts, which incorporate multiple (sometimes well over 50) unrelated funds. Funds that take part in a series trust are much cheaper to launch than funds that set up their own trusts. The downside to series trusts, however, can be that the trustees may not have a vested interest in the funds they oversee. If the trustees are spread thin, are highly paid, and have little or no investment in the funds they oversee, we would lean toward a Negative Parent rating. Northern Lights is one example of a less-than-desirable board structure, with nearly 100 funds under its umbrella (many of them alternative). The total compensation to each of its five trustees (as of Dec. 31, 2011) ranged from $40,000 to $105,000 annually, and not one trustee had an investment in any of the funds.

The table lists the 47 alternative mutual funds we have rated, and their respective Parent pillar ratings. 

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Nadia Papagiannis is an analyst with Morningstar.
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