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May 28, 2019 at 01:00 PM
As alternative mutual funds proliferate, Morningstar faces a classification conundrum: How can single categories include funds with entirely different characteristics?
The question has deep implications for advisors, who will have to look beyond star ratings or past performance and get a deeper sense of an alternative strategy’s inner workings before deciding whether it matches a client’s objectives.
We don’t dismiss Morningstar’s value to the advisory industry. For years, its database and star rankings have helped guide advisors in seeking equity or bond fund for clients. But this is an easier task when it comes to long-only, traditional asset classes.
Funds in the U.S. large-cap value, or international small-cap growth category, for example, will have relatively similar characteristics, making long-term ratings of such funds a more appropriate gauge of fund quality.
When it comes to categorizing alternative funds, however, Morningstar faces an unenviable task, and one that doesn’t provide easy answers or fixes. There’s simply much more variance in the fund characteristics of alternative strategies than long-only funds.
Often, the fund objectives and risks are so entirely different, one could argue they don’t belong in the same category at all. But where else should they be placed? And if funds are so different, how much value is there in comparing apples and oranges in a side-by-side comparison?
Morningstar’s long/short equity category provides an example of the classification conundrum, though there are big differences in individual fund characteristics within other alternative categories as well. Within the long/short category, gross exposure ranges between 14% to 342%. Net exposures range from 14% to 137% according to data from Morningstar’s database. Differences in beta are equally staggering, ranging from as low as 0.07 to as high as 0.90.
Adding to the confusion, long/short equity funds within the same category invest across entirely different markets. Many long/short funds are domestically focused, though the fund category also includes global, and even sector-specific funds.
