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Advisors split on Morningstar's new mutual funds

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Morningstar's plan to sponsor a new line of mutual funds in its managed accounts has some advisors wondering how the fund-rating firm will remain objective.

The research firm wants to launch its own open-end investment company known as Morningstar Funds Trust, which will consist of nine sub-advised mutual funds, according to its SEC filing.

Morningstar said the move aims to lower costs by removing a layer of fees paid to third-party managers.

Morningstar’s portfolios will invest in the funds which, in turn, will invest their assets in individual stocks, bonds, and other securities that have been selected by Morningstar, according to the filing.

The nine new funds include U.S. equity, international equity, global income, total return bond, defensive bond, multi-sector bond, municipal bond, unconstrained allocation and alternatives. They won’t be available before the fourth quarter this year, according to the documents.

“We expect these fees to be eliminated by using Morningstar sponsored funds in our managed portfolios,” Morningstar said in its SEC filings.

"Now Morningstar is putting more funds out there with no track record. It’s a bad idea,” says Jon Yankee, partner, FJY Financial.

The structural change is expected to result in a 20% net reduction in investor fees, Morningstar said.

But the potential for savings could come at a cost for Morningstar, some advisors suggest.

“It raises massive potential conflict of interest and credibility issues,” says Jon Yankee, partner of Reston, Virginia-based FJY Financial. “There are already more funds than we need as advisors. Now Morningstar is putting more funds out there with no track record. It’s a bad idea."

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Norman Boone, president and founder of San Francisco-based Mosaic Financial Partners, also called the offering a “poor move.”

“One of the reasons why Morningstar has been so successful is because of their independence,” Boone says. “Once they join the fray and become a competitor to those they judge and report on, they've given up their objectivity. I see this as a direct conflict of interest for them.”

Tim Baker, director of product strategy at Glastonbury, Connecticut-based Symmetry Partners, says the proposal puts Morningstar in the same group of strategists in recent years who have launched funds in which to wrap their model portfolios.

Baker urged caution in evaluating Morningstar's claims the move would reduce overall cost to an investor. "As with any other type of investment, there are many fees beyond the prospectus expense ratio that investors should consider when investing in a mutual fund," he says.

Morningstar is not the first research firm that tried to transition from a research shop to an investment shop. Value Line, the New York-based independent research firm founded in 1931, started its first mutual fund in 1950. It now runs eight mutual funds.

"You can tell us about performance returns all you want, but they’re not real. We wouldn’t preclude it just because it’s Morningstar,” says Michael Joyce, president, Joyce Payne Partners.

David Haraway, a financial advisor at LPL, says although he has experience with Value Line’s products for over a decade and trusts the firm’s research, he never recommends Value Line’s funds to his clients. “A good research shop doesn’t always transition to a good investment shop,” Haraway says.

Without track records, Haraway says he wouldn’t jump to Morningstar’s products either.

“They can run on somebody else’s money, but not on mine,” Haraway says. “I would say, ‘Good luck to Morningstar,’ and we’ll see how they do after three years.”

Responding to the critiques, Morningstar chief spokeswoman Nadine Youssef pointed out the funds are from a Morningstar Investment Management subsidiary providing sub-advisory services.

In order to remain neutral, Morningstar says the funds will not receive a Morningstar Analyst Rating, which is a qualitative rating, Youssef adds.

However, the funds will be eligible for Morningstar Rating, a quantitative measure based on the funds’ trailing risk-adjusted returns versus category peers, after obtaining three years of performance history, she says.

“We’ll continue to maintain a separation between the manager research analysts and the investment professionals in Morningstar Investment Management,” Youssef says.

Michael Joyce, president of Bethlehem, Pennsylvania-based Joyce Payne Partners, had doubts about Morningstar's proposal but was less critical.

“I think we would be neutral about it,” Joyce says. “We don’t invest in any funds that don’t have a track record anyway. You can tell us about performance returns all you want, but they’re not real. We wouldn’t preclude it just because it’s Morningstar.”

Laif Meidell, president of Reno, Nevada-based American Wealth Management, is also doubtful about any competitive advantage Morningstar would have over other fund managers.

“They are competing with a lot of experienced firms out there. Who are the Morningstar managers? Do they have track records to run the funds? Those would be my questions for Morningstar,” Meidell says.

As a fiduciary, Jim Burns, senior financial planner at Vintage Financial Services, says his firm always seeks to “remove any conflict of interest when and where possible.”

“We are focused on risk-, tax- and cost-adjusted returns to make sure we’re providing the best investment options we can,” Burns said. “We don’t care if were using a JP Morgan or Fidelity fund; we just want what is best for our clients.”

Other advisors were willing to give Morningstar's proposed offering a chance.

“Anything that drives down costs is beneficial to investors,” says Edward Kramer, an advisor at Abacus Planning Group in Columbia, South Carolina. “As long as they provide funds of good quality at lower cost I’m open to recommend to clients.”

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