We dissect the expense-related considerations for closed-end fund investing.
Many investors avoid buying closed-end funds because of their reputation for charging high fees. After all, Morningstar regularly notes that fees are often the best predictor of performance, so why consider an "expensive" CEF? Intuitively, the mechanics behind low fees and strong returns makes sense: The risk-adjusted benefits of active management are often unclear and inconsistent, but fees are always a sure thing. In more technical terms, fees represent negative alpha. Superior management teams occasionally overcome the high-fee hurdle through superior security selection and portfolio construction, but this is the exception rather than the norm.
All else being equal, many investors gravitate toward the fund (exchange-traded fund, CEF, or open-end fund) with the lowest fees. But while the decision is as simple as looking at the published expense ratios for ETFs and open-end funds, CEFs are a bit trickier. Leverage and share price complicate the picture, making it difficult to readily compare CEF expenses with those of other fund vehicles. Nevertheless, investors can make a few adjustments to arrive at a comparable number.
Leverage: Adjusted and Total Expense Ratios
Like other fund vehicles, management fees constitute the bulk of CEF expenses, along with a host of other miscellaneous fees (exchange listing fees, legal fees, audit fees, board of directors' fees, and so on). After accounting for fund size, CEF fees tend to be on par with those charged by similar actively managed open-end funds. Expenses are simple for CEFs that don't use leverage. Unfortunately, accounting for leverage is not straightforward.
Leverage is not free. CEFs pay dividends to preferred shareholders, interest on lines of credit, and so forth. Fund companies attempt to break these costs down by publishing two numbers, a total expense ratio and an adjusted expense ratio (though these terms are not consistent across fund firms). The former is meant to include the costs associated with leverage, while the latter is meant to strip out these leverage costs. But investors should avoid taking either metric at face value.
Unleveraged CEF expenses are likely to be on par with those of similar open-end funds, but the adjusted expense ratios of leveraged CEFs are almost always higher. This is because most CEFs charge management fees on total assets (shareholder equity plus the proceeds from leverage) as opposed to net assets (just shareholder equity). Applying management fees to total assets is standard industry practice, but we do not view it as shareholder friendly. This fee structure gives fund companies and managers an economic incentive to take on as much leverage as possible for the sake of generating higher fees. Fund companies often argue that they are entitled to more fees for managing more assets, but this reasoning is somewhat flimsy. Adequate leverage management certainly incurs a cost to the fund company (warranting slightly higher fees), but it is unclear whether each incremental dollar in leverage financing is as costly to manage. Some forms of leverage generate costs in addition to the extra management fees. For example, remarketing fees and liquidity fees for variable-rate demand preferred shares are often included in the adjusted expense ratio. This makes accurate comparisons across CEFs with differing leverage structures more difficult.
Meanwhile, the total expense ratio is meant as an all-in number, which includes the entirety of management fees and leverage costs. With fewer "adjustments," this number is often more reliable for comparison's sake. The following chart provides an example of how these two expense ratios are broken down:
The total expense ratio, though inclusive of most expenses, should be taken with a grain of salt. Dividends paid to auction-rate preferred shares (ARPS) are unlikely to show up in the total expense ratio because of a quirk in reporting requirements. For these funds, more accurate total expense ratios can be calculated by looking at the funds' income statements, which break down non-ARPS total expenses and dividends paid to preferred shareholders. The following back-of-the-envelope calculation makes the necessary adjustments: