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: The new methodology is in line with recent guidance from the Financial Industry Regulatory Authority, which stated that the expense ratios Morningstar publishes must match fund disclosure documents.
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. BlackRock Total Return (MAHQX), for example, uses reverse-repo transactions to obtain certain market exposures, and its stated expense ratio in Morningstar products has risen 24 basis points across all its share classes as a result. Within equities, 130/30 funds like AQR Large Cap Relaxed Constraint Equity (QLRRX) also look more expensive under the new methodology.
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.
BlackRock Global Long/Short Equity (BDMIX), for example, had more than 100% gross short exposure at the end of June. It used total return swaps to gain that exposure, however, so its stated expense ratio of 1.91% will not change as a result of the new collection methodology. Its category peer Vanguard Market Neutral (VMNIX), on the other hand, also has around 100% gross short exposure. It gains its short exposure by borrowing shares of that stock and then selling them on the market, with the expectation of repurchasing those shares at a lower price and thus turning a profit on the difference. Its brokerage charges an interest expense on the borrowed shares, and if those shares pay a dividend while the fund is borrowing them, the fund must pay the dividend. This method of shorting does lead to short interest and dividend expenses on the prospectus. Vanguard Market Neutral's expense ratio now appears to be 1.32% higher than before the collection change despite no changes to the management fee or other operating costs. In fact, excluding these investment-related expenses, Vanguard Market Neutral charges a rock-bottom 0.14% levy, earning a Price Pillar rating of Positive. Its BlackRock peer, meanwhile, gets a Price Pillar rating of Negative.
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.
Jason Kephart, CFA does not own shares in any of the securities mentioned above.
Kurt Marquis does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.