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Fund Spy: Morningstar Medalist Edition

The Worst Practice in Liquid Alternatives

Investors have a right to know how much they pay in fees, but some funds won’t come clean.

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The vast majority of liquid alternative funds do a fine job reporting accurate portfolio holdings and fees to investors. There are a handful, however, that take advantage of the SEC's current lax reporting rules on derivatives to camouflage their underlying strategies and the cost of those strategies. We've previously highlighted the poor disclosure around fees and portfolio holdings in some managed-futures funds, which is actually improving, but the unfriendly shareholder practice is starting to spread to multialternative strategies as well. To be fair, we're aware of only a small number of funds that are this opaque about fees, but ignoring or giving them a pass could possibly lead to more of this behavior, and that would be a terrible outcome for investors.

The practice pertains to funds that use total return swaps to access the net-of-fee returns of commodity trading advisors running managed-futures hedge funds. Because they are using a total return swap, instead of hiring the managers as direct subadvisors or investing directly in the hedge fund, the fund's aren't required to include the cost of the swap or the subadvisor's management and performance fees in the prospectus net expense ratio or in the annual report net expense ratio. The latter fee is a particular concern, as the 1940 Act prohibits mutual funds from charging a performance fee based on capital appreciation in addition to a management fee. That's not to be confused with performance-based fees, sometimes called fulcrum fees; these are allowed because a fund's management fee can rise or fall based on performance versus a benchmark, as is the case with  Fidelity Contrafund (FCNTX).

Jason Kephart does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.