Morningstar Solutions
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CEF Expenses
Slide 2: CEF Expenses

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.

Slide 3: CEF Expenses

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. To help make it easier, on Morningstar.com we include both reported expense ratios and adjusted expense ratios, which exclude the interest expense.
Slide 4: CEF Expenses

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.

Slide 5: CEF Expenses

Is the leverage actually an expense? In the example on the following slide, 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.

Slide 6: CEF Expenses
Slide 7: CEF Expenses

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.

Slide 8: CEF Expenses

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.

Slide 9: CEF Expenses

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%.

Slide 10: CEF Expenses

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.

Slide 11: CEF Expenses

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.

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Morningstar.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.

Slide 13: CEF Expenses

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.
Slide 14: CEF Expenses

Key Takeaways

  • 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.
Accompanying Video
CEF Expenses
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