by Thomas Kirchner, CFA
Better match with hedge fund categorizations.
Performance comparable between similar categories of hedge and mutual funds.
Liquid alts have tax benefits over LPs..
At the beginning of May, Morningstar reorganized its categories for alternative mutual funds in the U.S.[i]. The result is a closer alignment of alternative mutual fund classifications with hedge fund classifications, which are the gold standard for alternatives. It has been a slow road to get these asset classes to match up. Even though the strategies are often identical, they were classified differently for hedge funds and alternative mutual funds, making comparisons difficult. Especially investors with access to both types of funds were impacted and may often have ended up investing in higher priced hedge funds when equivalent mutual funds with lower cost and better tax efficiency were available.
The U.S. has lagged international markets in the adoption of hedge fund strategies in formats accessible to the public. Morningstar has often been the catalyst for change in the industry, and the recent reclassification is likely to accelerate an expansion of hedge fund strategies in '40 Act format.
All this comes amid a background of strengthening performance of alternative '40 Act mutual funds, which are competitive with hedge funds albeit with a far superior liquidity and operational risk profile.
Limitations of the '40 Act Space
We have come a long way since Morningstar first introduced a long/short category in 2006. Mutual funds that used shorting had been around since the 1980s, but had been lumped in with traditional style boxes. This led many in the hedge fund industry to make the false claim that mutual funds were not allowed to sell short – a powerful, albeit completely false marketing argument.
Since then, many alternative strategies have been launched, but unfortunately, not always for good reasons. Large fund complexes sometimes started funds that appear to have been driven more by marketing considerations than the availability of a good strategy run by a competent manager. Whenever Morningstar creates a box, fund marketing departments feel a need to offer a fund in that box.
Despite the growth of alternative mutual funds, the sector remains far behind true hedge funds in the U.S. The situation is different internationally, where the UCITS structure has attracted both assets and hedge fund managers. Originally, UCITS were created in the EU but these vehicles have been such a success that they are now recognized by and can be distributed in many non-EU countries from the middle East to East Asia and Latin America.
The key to success of UCITS, and the reason for the comparatively marginalized existence of U.S. mutual funds, is the difference in performance fees. While U.S. mutual funds allow only watered-down versions of performance fees, UCITS allows managers to charge such fees in the same way as they do in their flagship hedge funds. The result is that many leading hedge fund firms were willing to launch versions of their strategies in UCITS funds, but not in U.S. mutual funds.
In turn, the availability of brand name hedge fund managers in UCITS vehicles made this structure acceptable to investors, including institutions, while alternative U.S. mutual funds continue to suffer from investor snobism.
The new categories
These are the new Morningstar category classifications for alternative mutual funds, along with similar HFRI categories and their respective 5-year annualized returns:
Morningstar retired a number of other categories. Unfortunately, this includes the bear market category, so that short-selling funds no longer are easy to find. We question whether this decision was driven more by performance considerations of the underlying funds. The result is that hedge fund classifications remain better for short-selling funds.
As can be seen from the performance in the table above, the perception that hedge funds are superior to their mutual fund peers is no longer true. In a few categories, mutual funds even outperformed hedge fund over the last five years. This is even more remarkable considering that leverage tends to be higher in hedge funds, which also have the benefit of locking up their investors for long periods of time, whereas mutual funds give their investors daily liquidity.
Tax efficiency
Limited partnerships benefit from pass-through taxation, which sounds great until you look at the details. Generally, pass-through taxation is inferior to Subchapter M taxation of mutual funds, which is similar to how REITs are taxed. The problem with pass-through taxation is that, as the name suggests, all incomes and expenses are passed through to the taxpayer. Once they show up on the taxpayer's tax return, they are subject to limitations on deductibility. For example, management fees can only be deducted to the extent that they exceed 2% of the taxpayer's AGI. Therefore, you could be in a situation where a fund passes through short-term capital gains of 2%, which are fully taxable at income tax rates (over 50% in NY or CA), resulting in a net return of 1%. Once you factor in a 2% management fee, the net after-tax return of the fund is negative, approximately -1%. In contrast, a mutual fund, as in a REIT, the management fee and all other expenses are deducted from gains, resulting in a net after-tax return of zero, which outperforms the hedge fund structure solely because of the hedge fund's unfavorable pass-through tax treatment.
[i] Erol Alitovski: “Introducing the New Alternative Morningstar Categories.” morningstar.com, April 29, 2021.
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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.
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