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The Price Pillar

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

Nadia Papagiannis, CFA, 10/31/2012

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 Price pillar.

The Price Is Right
There's no such thing as a free lunch, of course. But Morningstar believes, as do the academics, that the more a fund charges relative to its peers, the worse it will perform over time. We also believe that strategies in more-efficient asset classes such as large-cap stocks should charge less than strategies in less-efficient classes, such as emerging-markets stocks. Similarly, it makes sense that alternative funds are generally more expensive than traditional funds, as they require more trading and risk-management skill, and as there are few cheaper substitutes such as ETFs.

But even in alternative strategies, there are decently priced options. For example, Gateway Fund GATEX charges only 94 basis points for its A-shares, much less than the average long-short equity fund (2.04%, the average of all share classes of all funds in the long-short equity category), and much less than other A-share alternative (including other categories) mutual funds, which charge an average of 1.74%. Performance, naturally, factors into the mix. Just because a fund is cheap doesn't mean it's good. But if a fund is already good, a reasonable price tag bolsters our confidence in its future performance.

This table lists the 48 alternative mutual funds we have rated and their respective Price pillar ratings.

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Nadia Papagiannis is an analyst with Morningstar.
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