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Fund Spy

Tallying Up the Cost of Short Interest Expenses

The costs of shorting aren't always visible, but they can exact a price.

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A common source of confusion--both from fund companies and investors--concerns how Morningstar treats short interest and dividend expenses in our published expense ratios. This is particularly relevant to alternative mutual funds, because shorting is a commonly used technique in alternative strategies. Short interest and dividend expenses drive large differences between how Morningstar and fund companies report expenses for funds--for example, Bronze-rated  Vanguard Market Neutral (VMNFX) reports an expense ratio of 1.64%, while Morningstar reports its expense ratio as 0.25%. Vanguard includes short interest and dividend expenses in its net expense ratio, while Morningstar does not. Understanding how short expenses work can help reconcile apparent inconsistencies in how Morningstar and fund companies report expenses, as well as clarify the cost of one of the key techniques of alternative managers.

To begin, let's review what short interest borrowing charges and remittances on dividends paid actually mean and where they come from. Shorting (or short-selling) a stock involves borrowing shares of that stock and then selling them on the market, with the expectation of repurchasing those shares at a lower price and thus turning a profit on the difference. Managers of alternative funds may use shorting as a way of generating alpha or as part of a broader hedging strategy designed to reduce market exposure.

Josh Charlson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.