Perhaps it was only a matter of time before Morningstar decided to put its stamp of approval, and disapproval, on alternative mutual funds.
And by all measures, the fund research firm should.
Assets held in alternative mutual funds have increased 128% since October 2008, reaching $99 billion as of March 2012, according to the Chicago-based research shop. Additional research by Cerulli Associates found that asset managers expect alternative mutual funds will comprise more than 15% of all mutual funds in 10 years.
Last month, Morningstar introduced the Morningstar Analyst Rating and Global Fund Reports for approximately 40 alternative U.S. mutual funds. These are funds which represent about 75% of the alternative fund universe by assets. Over the next year, the company plans to increase its alternatives coverage to approximately 100 funds.
Initially, Morningstar analysts assigned a Gold rating to the TFS Market Neutral (TFSMX) fund, a Silver rating to nine funds, a Bronze rating to seven funds, a Neutral rating to 17 funds, and a Negative rating to six alternative funds, including the Princeton Futures Strategy (PFFAX), Guggenheim Managed Futures (RYMTX), Aberdeen Equity Long-Short (MLSCX), Hatteras Alpha Hedged Strategies (ALPHX), Goldman Sachs Absolute Return (GARTX) and the Hussman Strategic Growth (HSGFX).
Nadia Papagiannis, director of Morningstar's alternative fund research, said that her firm always intended to rate alternative funds but wanted to assess their pillars slightly differently than traditional managers (see "Behind the Pillars Of a Morningstar Rating," June 18, 2012).
For example: In traditional funds such as those focusing on large-cap strategies, Papagiannis said her firm expects the manager to have more than $1 million of his or her own net worth in that fund.
"But in the alternative space, some funds like market neutral [funds] are not exactly core holdings so it's not as much of a requirement as in traditional funds but we do look at managers with more than $1 million invested even more favorably," she said.
In fact, the TFS Market Neutral fund got its Gold rating partly because "besides keeping transaction costs as low as possible, management has demonstrated excellent stewardship in other respects," according to Papagiannis. "All of the six portfolio managers invest in the fund, and three of the six have invested more than $1 million," she wrote.
Eric Newman, a portfolio manager at TFS, said that his firm is very pleased that Morningstar has recognized the shareholder-friendly structure of its mutual fund. "We don't charge loads, 12b-1 fees (annual marketing or distribution fees on a mutual fund), and we don't use soft dollars ( payments made by mutual funds to their service providers in the form of business to the brokerage)," he said.
"We think that ratings like these are valuable to the alternative investor where often it is difficult to judge a fund solely based on its performance. Owners and portfolio managers are required at TFS to at least invest half of their liquid assets in TFS-managed funds."
Papagiannis said that risk management is "very, very important" for alternative funds and Morningstar will focus on that, if the process is transparent and repeatable. But the firm will be a bit more lax on the managers' firm structure because "not all alternative firms are backed by giant parents as some traditional funds" such John Hancock Funds, which is backed by Manulife Financial, the Canadian financial services firm, according to Papagiannis.
Also, alternative managers will have some leeway in terms of their track record because Morningstar considers a five-year track record to be "very long" for these managers simply because they haven't been around for very long.
In terms of the fees, Papagiannis said Morningstar will look at fees "very skeptically" because it believes that long-term, lower-fee funds are going to outperform higher ones in the alternative space "but we do look at the fees relative to other alternative funds and similar share classes of those funds."
For example, Morningstar's gave Hatteras' fund a Negative rating partly because of the fund's "outrageous fees." Its 399-basis-points net expense ratio exceeds that of all other funds in the category, according to analyst Mallory Horejs.
"To be fair, investing in hedge fund managers is never cheap (especially if they forgo incentive fees, which mutual funds cannot charge), and this fund offers access to what management believes are the best. But liquid access to hedge funds is no longer worth a hefty price tag," she wrote.
Bob Worthington, president of Hatteras, is taking Morningstar's Negative rating of his fund in stride. "You never agree with everything that one firm puts out, but they're a smart group and they've done a good job," he said. "We are in contact with their analysts so they know what we're doing."
Morningstar has done a "great" job of rating traditional funds, he notes, and as "they continue to do more and more research on the alternative side, they'll get better and better at it. It's a good thing when you have objective research."
However, advisors should also do their own due diligence if they want a true picture of what they investing in. "Our process, while it is in a mutual fund structure, is more akin to a true institutional type of funds of funds that used to be done in a limited partnership format. So there's a lot more beneath the surface," he said.
But Morningstar is not stopping with alternative funds. Going forward, the firm will begin covering alternative exchange-traded funds within the next six months. "We have already covered four alternative ETFs and we are going to expand that," said Papagiannis.
So what kind of reaction has Morningstar received from the alternative crowd about its latest initiative? "I haven't talked to anyone yet, but I'm pretty sure we'll have some pretty negative stuff because we always do," said Papagiannis.
However, she noted that the firm is not looking to "have a war with managers" and that the ratings are not set in stone.
"We talk to managers and if they can explain to us that this isn't the right way to look at it and if we agree, then we would alter the rating," she said.