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Beware of Managed-Futures Funds Hiding Fees

What some mutual funds of CTAs are doing to fleece investors.

Nadia Papagiannis, CFA, 11/15/2012

Morningstar's managed-futures mutual fund category, which debuted in April 2011, now has almost $9 billion in assets and 35 constituents. More than half of those 35 constituents are funds of commodity trading advisors (CTAs), or subadvisors who manage one or more underlying commodity futures trading pools. These subadvisors charge management fees of about 2% and performance fees of 20% or more, just like hedge funds. On top of that, the mutual fund advisor charges its own management fees, and fundholders must pay traditional mutual fund operating expenses, such as 12b-1 and transfer agent fees. Those fees can really add up. Quantitative Managed Futures Strategy QMFAX, for example, posted a net expense ratio of 8.35% in its last annual report. What's appalling about some of these CTA-based mutual funds, however, is not necessarily the level of fees they pay, but the fact that some do not disclose their fees. And the SEC isn't making them.

Tax Code Shenanigans
Before we get into which mutual funds of CTAs are hiding fees, investors must first understand why they are able to do so. The explanation goes back many years. Mutual funds are technically not allowed to own commodity futures (more than what is allowed by the 10% "bad income" rule, that is), because when the mutual fund tax laws were written in the 1980s, commodity investing and futures exchanges were in their infancy. As mutual funds began trading commodity futures in the late 1990s (tracking the S&P GSCI or the Dow Jones UBS Indexes, for example), mutual funds and the IRS had to get creative. Mutual funds could trade commodity futures through special vehicles--swaps or controlled foreign corporations--which were treated as "securities" rather than "commodities" for tax purposes, thereby avoiding any "bad income" issues. The problem with these special vehicles is that there is no transparency --neither the trading positions nor the underlying fees are required to be disclosed according to SEC rules, which were written even before the tax code.

New Kids on the Block
When mutual funds of CTAs came on the scene in late 2009, they took advantage of the arcane mutual fund and tax regulations. Whereas mutual funds cannot technically charge performance fees (only fulcrum fees--management fees that ratchet up and down based on performance), mutual funds of CTAs got away with it because the swap or controlled foreign corporation barrier effectively hid their fees. What's more, the SEC never required these funds to include their second layer of management and performance fees.

The Commodity Futures Trading Commission (CFTC) got wind of these antics, however. In 2011, the Commission attempted to reverse an exemption to rule 4.5, which granted 1940-Act registered mutual funds relief from CFTC registration and CFTC disclosure rules. These disclosure rules proposed, among other things, that mutual funds of CTAs publish break-even tables with detailed listings of all fees. Some CTA mutual fund sponsors, namely Altegris and Equinox (Mutualhedge), jumped the gun and began disclosing all of their fees before these proposed rules were even adopted. Others followed suit. Things were looking good for investors.

One Step Forward, Two Steps Back
Then the mutual fund industry pushed back. Many of the existing CFTC rules conflicted with SEC disclosure requirements, so the CFTC proposed, in March of 2012, rules that harmonized both sets of regulations. Per these harmonized rules, CFTC registration would still be required for managed-futures mutual funds, and the break-even table listing all the fees would be required to be published in the forefront of the SEC prospectus. The harmonization efforts weren't good enough for the Investment Company Institute, the primary mutual fund industry trade group, who sued the CFTC in April 2012. In October 2012, the lawsuit went to court, and the current status of mutual fund registration with the CFTC is still undecided.

In the meantime, some very bad behavior has started up. Grant Park Managed Futures GPFAX (Knollwood Investment Advisors) has stopped disclosing any reference to their underlying CTA management and performance fees at all. Whereas in the fund's Jan. 31, 2012, annual report, the net expense ratio was reported at 3.55% and included the underlying CTAs' performance and management fees, the September 2012 prospectus includes no reference to any underlying fees--in the prospectus fee table or as a footnote to the fee table. The new expense ratio, naturally, looks much more attractive: 1.97%.

Furthermore, Knollwood has represented to Morningstar that the fund's next annual report disclosures will be consistent with the new prospectus format--meaning management will likely bury the additional fees in the annual report as well. Management's rationale is that the mutual fund now accesses the underlying CTAs through a swap agreement, and a swap, like any other security, doesn't have to report its baked-in transaction costs. But smart investors know when they're being blatantly deceived.

Morningstar is catching wind that other firms are contemplating similar swap and fee-disclosure arrangements. Of course, if one firm doesn't report their fees, why should anyone else?

Nadia Papagiannis is an analyst with Morningstar.

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