Morningstar's Kephart: Alternative Funds Buck the Low-Cost Trend

Thursday, 28 Aug 2014 07:43 AM

By Michael Kling

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Investors have been fleeing from high-cost mutual funds to cheaper competitors, acknowledging that low-cost equals better long-term performance.

Not so with alternative mutual funds. It's the only broad Morningstar category where more money has been flowing into higher-cost funds.

From 2011 to 2013, 121 percent of the net $432 billion being invested in mutual funds went to the cheapest fifth, notes Morningstar analyst Jason Kephart, explaining that the number is over 100 percent because investors have been moving money from higher-cost funds to cheaper rivals.

Editor’s Note:
Dow Predicted Will Hit 60,000 — Buy These 4 Stocks Now


In the alternative funds category, just 36 percent of the net $58 billion inflow went to the cheapest fifth.

Why is that? In part, simple performance chasing, he theorizes.

In addition, some argue alterative funds are cheap as compared with hedge funds. You get what you pay for, they say.

Not true, Kephart counters. Morningstar has found high-quality yet relatively inexpensive alternative funds.

"Every dollar you don’t pay in fees is an extra dollar added to your total return," he writes. "What's important to remember is that investors have more control over the fees they pay than virtually any other component of performance."

If history any guide, cheaper alternative funds will outperform their more expensive brethren, Kephart predicts. Plus, high-cost funds are more likely to be liquidated.

"Over time, it's likely that more investors will see the light and turn their eyes (and wallets) toward more-affordable alternative options," Kephart explains.

A cheap alternative fund would be considered expensive for a typical mutual fund. An alternative fund needs a fee of 1.29 percent to qualify for the cheapest quintile in its category. A fee of 1.25 percent for a large-cap fund would be considered above average.

MainStay Marketfield, the largest alternative fund, has a 1.52 percent expense ratio for its institutional share class, a fee that's average for the sector.

Although alternative funds can use hedge-fund tactics such as shorting stocks and buying futures contracts, they are cheaper than hedge funds are, which typically charge steep management and performance fees, notes Kiplinger's Personal Finance.

They're also more transparent and can be sold on a daily basis.

However, many lack long-term track records and can underperform the market. The average alternative fund gained 2.9 percent, while the S&P 500 gained 18.8 percent the past five years through June 30.

Editor’s Note: Dow Predicted Will Hit 60,000 — Buy These 4 Stocks Now

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