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A Fee Methodology Update Makes Some Funds' Fees (Appear to) Swell

The fund net expense ratios Morningstar publishes now include costs from interest and dividend expense, but that won't affect Morningstar Analyst Ratings.

On July 31, Morningstar began including costs associated with interest expense and dividends on borrowed securities in the fund's annual report and prospectus net expense ratios. The prospectus net expense ratio is displayed on Morningstar.com and used to calculate the Morningstar Fee Level. This change directly affects about 550 mutual funds, or 6% of all U.S. mutual funds and exchange-traded funds, as of the end of July. Most of the affected are alternative strategies that use shorting as a regular part of their process, but some bond funds that use certain instruments are also affected, as are a handful of equity funds. This article will address frequently asked questions about the methodology change, its effect, and why it will not change any Morningstar Analyst Ratings.

Q: Why has Morningstar changed its fee methodology?

A: Morningstar made this methodology change so that our published net expense ratio data point would comply with existing regulatory guidance.

Q: Which categories of funds are most affected?

A: Liquid alternative funds are the most affected as Morningstar requires funds to have at least 20% gross short exposure on a consistent basis to be classified in a Morningstar Alternative Category. Outside of liquid alternatives, funds that obtain leverage through borrowing, as well as bond funds that use instruments such as reverse-repo transactions or tender-option bonds (specific to municipal-bond funds) have also seen expense ratios rise.

Q: Does this affect other data points?

A: The Morningstar Fee Level, which breaks funds into quintiles that range from Low, for funds with expenses lower than 80% of peers in their distribution channel, to High, for funds with expenses higher than 80% of peers, is affected by the change.

Additionally, the gross returns Morningstar publishes, which uses the trailing annual report net expense ratio to back out the expenses from the total return, will also experience an impact owing to the adjustment of the past three years of annual report net expense ratios.

Q: Will this affect Price Pillar and Morningstar Analyst Ratings?

A: No. Philosophically, Morningstar analysts view short interest and dividend expenses as trading costs that are intrinsic to a fund's strategy. For the same reason, Morningstar excludes brokerage costs from the annual report and prospectus net expense ratios of all funds (this practice will continue).

The use of the reported interest and dividend cost in the prospectus also doesn't allow for apples-to-apples comparisons across funds. Depending on the leveraging techniques employed by the fund, the fund may or may not be required to report interest or dividend expense. Funds that employ shorting strategies or reverse-repo transactions are required to report interest expense in their filings, whereas funds that employ futures, swaps, TBAs, and forwards are not required to report the cost associated with those instruments as interest expense.

Interest and dividend costs in general can vary widely over time and across funds depending on the economic environment, the tools involved, and the magnitude to which they're being used. Because of these differences, Morningstar analysts will continue to back out all interest and dividends on borrowed securities in order to compare a consistent value across funds when determining Price Pillar ratings and overall Analyst Ratings.

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