How Morningstar Evaluates Semiliquid Fund Fees

How do you compare fees across semiliquid funds when every fund reports incentive fees, hurdle rates, and expenses differently?

In this video, Morningstar’s Jason Kephart explains why fees are one of the hardest places to get an apples-to-apples comparison in the growing semiliquid market. As Morningstar expands its Medalist Ratings coverage, from about 25 semiliquid funds today to roughly 50 by year-end, the team found that the prospectus net expense ratio, long its default fee measure, doesn’t always capture incentive fees consistently. Sometimes those fees aren’t included at all.

Kephart introduces a new methodology that applies one consistent return assumption per asset class and focuses on management, operational, and incentive fees. It strips out interest costs as a cost of doing business for leveraged strategies. The result is a truer picture of each fund’s economic cost, including outliers. One fund’s prospectus shows 40 basis points, but under the new approach its cost is closer to 6%. The methodology debuted October 16, and ratings on existing funds will be updated shortly after. Morningstar expects some upgrades and a few more Medalists as a result.

Jason Kephart: As Morningstar has been really focused on semiliquid funds, we obviously started rating them. We rate around 25 today, and we plan to have Medalist Ratings on about 50 by the end of the year. One of the things we realized early on is that fees are one of the most challenging places to make sure things are apples to apples, because we at Morningstar think fees are a really important consideration for investors.

Kephart: Being able to compare semiliquid funds, two funds in the same vehicle in the same category, isn’t always as straightforward as we would like. When it comes to things like incentive fees, there’s a lot of variation in how people report them. Morningstar has always defaulted to the prospectus net expense ratio as our guiding light for fees, since that’s supposed to be the forward-looking expectation. What we’ve seen is that those don’t always reflect the actual incentive fees. Sometimes they might not even be in there.

I would add we do strip out interest rate costs, as we see that as a cost of doing business for a strategy that’s going to use leverage. So we’re really focusing on the management fee, operational fees, and then incentive fees. That’s our key focus.

Kephart: What we came up with is a way to rightsize a lot of these funds by having a basic return assumption for each asset class. If we have one consistent return assumption across all of them, then we can compare apples to apples all these different fee structures. Some have different hurdle rates, some have different incentive fees, some just charge flat fees. What this is really going to do is allow us to get a much better look at who’s actually offering a better deal, or a more expensive product, to investors. I think this is really cool, and it’s going to help us steer investors in the right direction.

I would note we haven’t seen a lot of fee competition in this space yet. We expect that will happen over time, naturally, but there are still a lot of people using the classic one and a quarter, 12.5% incentive fee with a 5% hurdle rate. The challenge is that even though we know a lot of the fee structures are the same, the prospectuses can vary a lot. So this is really going to help us.

Kephart: You can see a snapshot of what changes. For the most part it’s moving around a little bit, but there are some outlier funds where, when we use the actual fee structure and a return assumption, you get a much truer sense of the economic cost. One fund’s prospectus says 40 basis points, but if you treat it the same as every other fund in its category, it’s more like 6%. So it’s actually one of the more expensive ones. Before we introduced this methodology, that fund might have gotten a pass, or it might have impacted the peer group analysis. Now we’re going to have a much better sense of it.

This methodology is debuting October 16th. We’ll be rerating all the funds we currently have ratings on shortly thereafter, so you will see some changes. Generally what we’ve seen is that this actually causes some rating upgrades, just by having a better fee comparison. So you should probably expect to see a couple more Morningstar Medalists among the funds we already rate.