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For Closed-End Funds, Cheaper Isn't Necessarily Better

When it comes to expenses, CEFs are quite different than open-end mutual funds.

Mike Taggart, CFA, 10/12/2012

Perhaps the most common complaint I hear from investors who have decided not to invest in closed-end funds is that they are so expensive relative to open-end fund investment alternatives. It's a good point, but it misses the other part of the question: What do you get for that expense?

This week, we continue our series on CEF basics by looking at expenses. We found that, at least for their most recent fiscal years, CEFs as a group are on average more expensive than open-end mutual funds as a group.

Blame It on Leverage
Why are CEFs typically more expensive?

For any fund, closed-end or open-end, management fees tend to be the highest expense on the year-end income statement. These fees come from the management contract between the fund and its investment manager. One cause for CEFs' higher costs could be that CEFs charge higher management fees than their open-end competitors. Anecdotal evidence does not support this--we often find that a CEF charges the same management fee percentage as a sister fund with an open-end structure, with one major difference discussed below.

Instead, higher CEF expenses come from two factors. First, most CEFs typically assess the management fee against total--not net--assets. In such cases, the management fee is also charged against any structural leverage (lines of credit or preferred shares, typically) that the fund has. Second, if a fund incurs interest expense (most likely, from a line of credit), that interest expense by law must be included in the CEF's expense ratio. This makes sense, because the CEF's common shareholders bear the cost of that expense. What does not make sense is that if a fund has leverage through preferred shares, the distributions to preferred shareholders do not have to be included in the expense ratio, even though the CEF's common shareholders still bear the cost of this leverage.

Three Illustrative Examples

The table above shows three fictitious funds and how the use of leverage affects the funds' expense ratios. All three charge a 1% management fee on total--not net--assets, and all three have $200,000 in other costs. The language around management fees tends to differ; some funds charge a percentage of average daily assets, and others assess weekly or even monthly average assets. For the sake of simplicity, we are assuming the asset amount doesn't change over the period in question. Obviously, given portfolio performance, this wouldn't be the case in the real world.

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.

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