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Closed-end fund expenses

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Like mutual funds and ETFs, a CEF has a reported expense ratio. However, there are a couple of factors that make CEF expense ratios a little different. If it's a debt-leveraged CEF, the expense ratio includes interest expense. Most leveraged CEFs exact an expense against not only net assets, but also the leveraged assets.

Leverage, interest expense, and expense ratios

According to the Investment Company Act of 1940, CEFs that issue debt to achieve leverage must include the interest expense that they pay on that debt in their expense ratios. This raises two issues:

  1. Leverage achieved through preferred share issuance does not have to be included, even though common shareholders experience that payment to preferred shareholders just like they experience the payments to bond creditors.
  2. The inclusion of the interest expense makes comparison to non-leveraged CEFs and mutual funds difficult.

Learn how to locate Total Expense ratios on Fidelity.com.

Even though interest expense is a true expense, it also brings a benefit: the excess gain achieved from the leverage. To assess the true benefit of the leverage, one must calculate the excess return from the leverage and then subtract the cost of that leverage.

Is the leverage actually an expense? In the example below, the leverage actually contributed net income of $3 million to the fund during the period. In fact, as long as the total return of the portfolio exceeds the cost of the leverage, using leverage will be profitable. While interest expense is definitely an expense, it's an expense that can have calculable benefits.

Leveraged Fund
Net Assets ($mil) $100
Shares Outstanding (millions) 10
NAV Per Share $10.00
Leverage ($mil) $50
Total Assets(Net Assets + Liabilities) $150
Leverage Ratio 50%
NAV(Leveraged)* $10.00
NAV Total Return of 10%
Total Assets Increased 10% $15
Amount Contributed by Net Assets $10
Amount contributed by Leveraged Assets $5
Leverage Costs
$50 million of Debt issued at 5% Interest
Annual Interest Expense $2
Net Benefits of the Leverage 
Amount Contributed by Leveraged Assets $5
Annual Interest Expense $2
Net Benefit $3

*Absent portfolio value changes. NAV is the same whether leveraged or unleveraged.

Expense ratios: Seeing through the obfuscation

All CEFs must report their expense ratios according to a formula set forth by the Securities and Exchange Commission. The expense ratios are expressed as a percentage of average net assets. Most leveraged CEFs levy management fees against total assets, not just net assets, though this is not considered a best practice. Doing so results in higher management fees.

A management fee of 0.50% on a $500 million unleveraged fund is $2.5 million. If there is an additional $250 million in leverage, the fund provider can rake in an additional $1.25 million. The argument that it would cost more to manage a $750 million leveraged portfolio versus a $500 million unleveraged fund does not hold water. Investment management is a highly scalable business, meaning higher assets under management do not correlate highly with additional costs. Because such funds levy fees against total assets but must report expense ratios against net assets, their expense ratios are typically relatively high.

Let's use our previous example, and assume simplistically that the CEF has no other expenses. Let's further assume that the average net asset value remained the same during the year. Furthermore, the leverage was achieved through preferred shares, so there is no interest expense to muddy the waters.

The reported expense ratio would be calculated as:

Expenses ÷ average net assets = $3.75 million ÷ $500 million = 0.75%.

But the management fee was only 0.50%, so how can the expense ratio be 0.75%? This is due to the fact that common shareholders, the owners of the net assets, are paying fees on borrowed assets as well, in this example. The providers of leverage are paid a fee, either a preferred share dividend or an interest payment, in return for letting common shareholders use the borrowed funds. Common shareholders are already paying a fee to use the funds, and the additional assessment of management and/or administrative fees against the borrowed funds takes more money away from the common shareholders.

Less scrupulous fund executives realize that the high reported expense ratios, relative to less leveraged or unleveraged CEFs, make their fund look less appealing. They also realize that by law, they must report the expense ratio properly. So, what is to be done? They report several other expense ratios, along with the official expense ratio.

Most of the time, the thin explanation is that they want to educate investors as to the various ways one can look at expenses. We call these unofficial ratios "pro-forma expense ratios," as they are computed however the fund family wishes to compute them. Investors should ignore pro-forma expense ratios. Fidelity.com provides both reported ("official") expense ratios, and for debt-leveraged funds adjusted expense ratios.

If executives truly wanted to educate their shareholders and the readers of their annual reports, they would include tables showing the benefits of leverage and the total costs of that leverage. They would also be more transparent about all of their costs, and define those costs clearly. There is no need for pro-forma expense ratios.

Key takeaways

  • CEFs that issue debt to achieve leverage must include their interest expenses as part of the expense ratio.
  • For such CEFs, it's important to look at the adjusted expense ratio (with the interest expense excluded) and to analyze whether the leverage has been profitable.
  • Many leveraged CEFs assess management and/or administrative fees against borrowed money as well as against net assets.
  • This is a widespread practice, but we do not believe it is a best practice.
  • The resulting high reported ("official") expense ratio, properly calculated as a percentage of net assets, is a product of the fund's expense policy.
  • To obfuscate the high reported expense ratio, some fund families include multiple unofficial expense ratios in their regulatory filings and marketing materials.
  • Do not be fooled by the unofficial expense ratios; they are attempts to justify another cost on the leverage, aside from the cost that is due to the providers of the leverage.
  • There is nothing wrong with charging fees against borrowed assets, but fund families shouldn't try to deny the resulting high expense ratios.
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©2012 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
Article copyright 2012 by Morningstar, Inc. Reprinted with permission from Morningstar, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Closed end funds may trade at a discount (or premium) to their NAV and are subject to the market fluctuations of their underlying investments. Shares of closed end funds frequently trade at a market price that is a discount to their NAV. Closed end funds are subject to management fees and other expenses.

The Closed End Fund Screener may include closed end funds not registered under the Investment Company Act of 1940

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