The SEC Should Muzzle Former Hedge Funds

Surprise! This column follows up February's account, "When Hedge Funds Convert to Mutual Funds." (This sequel stands on its own; don't feel obliged to review the original.)

That article featured the travails of Catalyst Hedged Futures HFXAX, which dropped 15% during an otherwise tranquil week. (Since that time, the fund has partially righted its ship, but it remains down almost 16% for the year to date.) That nosedive came as a shock to shareholders, as nothing in the fund's 12-year history suggested that it could fall like that.

But here's the thing: The fund isn't 12 years old, not as a mutual fund. Its prospectus lists an inception year of 2005, and shows trailing 10-year returns, but before Aug. 30, 2013, Catalyst Hedged Futures wasn't a registered mutual fund. It was a limited partnership--a hedge fund, to use the term broadly. Which means that the fund struck ice not in its 13th year of mutual fund operations, as suggested by its performance history, but instead during its fourth year.

Bait and Switch This sort of thing happens a lot: Former hedge funds that convert into mutual funds, port their track records, and then behave differently--usually worse--than their histories suggested.

There are several reasons for it. The simplest, and most common, is reversion to the mean. There are thousands of hedge funds, operating quietly, known only by their small number of shareholders and, perhaps, a few hedge fund databases. (However, as reporting to the databases is strictly voluntary, some hedge funds can't be found even there.) Some perform unusually well, and those are the funds that tend to be converted--and as their good fortune fades, their returns slide.

There are other possible explanations. One is that the converted fund achieved its record while tiny and then became too large to operate as effectively after opening to the public. Another is that, although the SEC will not permit newly created mutual funds to cite their hedge fund histories unless their investment practices remain unaltered in "in all material respects," something changed after the conversion. The fund company, after all, gets to make that call, not the SEC.

The causes matter not. The point is, the performance figures for hedge funds that have converted into mutual funds are not helpful. They are such unreliable guides to the future that they shouldn't be published at all.

Morningstar's Change of Heart Morningstar currently minimizes the impact of preconversion histories in two ways. First, although the total returns are computed and published, those numbers are not used for assigning percentile rankings. Despite this year's setback, Catalyst Hedged Futures has its Morningstar Category's highest 10-year returns. However, it cannot claim to be Morningstar's top fund for the decade, because it is not ranked as such.

Second, preconversion histories are discarded when calculating the Morningstar Rating for funds, aka the star rating. Thus, Catalyst Hedged Futures is rated only for the shortest of Morningstar's ratings time periods of three years, five years, and 10 years. (That rating, unsurprisingly, is 1-star.)

This position was devised as a compromise. With the notable exception of how funds account for their borrowing costs when computing expense ratios--an arcane debate that is covered here--Morningstar has always followed the SEC's rules. Doing so reduces confusion; when Morningstar's figures don't match what funds publish, people understandably become puzzled. Thus, believed those who created Morningstar's policy on fund conversions, the soundest approach was to keep the data, as the SEC allows, but downplay its importance.

That policy is not good enough. Morningstar's research team, I am happy to report, has come to the same conclusion that I have gradually reached: that showing extended track records is an investor drawback, not a benefit. With some funds, on some occasions, the additional numbers will provide a fuller, more-accurate view of how the fund will perform in the future. But often they will accomplish the opposite. And there is no way that an investor can tell the difference between the two situations. They look identical from the outside.

So, it's time for a change. Sometime soon--I can't give an exact date, because the operational details haven't yet been finished--Morningstar will remove all hedge fund histories from mutual funds (or exchange-traded funds, in the unlikely event that such a conversion occurs). If hedge funds wish to succeed as mutual funds, they will need to establish their track records from scratch.

(Note: This revision will not affect all converted funds. Sometimes, closed-end funds open up, and become mutual funds. As both fund types are registered funds (meaning they comply with the Investment Company Act of 1940), Morningstar treats the combined track record as a single entity. Also, collective investment trusts--a version of institutional fund--occasionally convert into mutual funds. They are and will be treated as hedge fund conversions now are: Their data will be displayed, but rankings and star ratings will not be calculated.)

A Public Request I urge the SEC to follow suit.

I appreciate the commission's reasoning when deciding to permit hedge fund performance histories. If possible, it wishes to give investors more rather than less. Let them decide what information is relevant, rather than withhold data in the assumption they will misinterpret it. (Amusingly, in the early 1990s, several fund companies used that argument to defend their practice of not disclosing the names of their funds' portfolio managers.)

That is the correct general principle. However, it fails in this specific case. There is no way to use those performance records profitably. It can't be done, not without knowing the sponsoring firm's history of fund startups, to determine how many funds were incubated but never taken public, and not without studying the fund's portfolio holdings over time, to see whether its investment practices truly are materially unchanged. Such information is not available and will not become so.

So what is the point of clues that can't be deciphered? In this instance, less truly is more. Let's give investors what helps them most and settle on a single policy used by Morningstar and the commission, as opposed to having two approaches.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.