By Michael Rawson, CFA
In comparing the costs of exchange-traded funds and index funds tracking similar segments of the market, every basis point matters. Making apples-to-apples comparisons of the expense ratios of small-cap ETFs and index funds can be difficult. That's because those funds tracking indexes with even a minuscule weighting in business development companies, or BDCs, are forced to include "acquired fund fees" in their prospectus net expense ratio.
The SEC requires funds to include in their prospectus expense ratio the pro rata share of any expenses from their investments in other funds. Normally, this is only relevant for funds of funds. A fund of funds is forced to list its management expense ratio in addition to the expense ratio of all its underlying funds. For example, PIMCO All Asset (PAAIX) lists a prospectus expense ratio of 0.88%, which is the sum of 0.12% in management fees and the 0.76% weighted average expense ratio of its underlying funds.
Business development companies are specialty finance companies similar to private equity firms that invest, through debt and equity investments, in private companies or thinly traded securities of public companies. Technically, BDCs are registered under the Investment Company Act of 1940 as closed-end funds under a special provision enacted by Congress in 1980. Consequently, any fund that owns BDCs is required to list the expenses of that BDC in its prospectus net expense ratio. Like open-end mutual funds, BDCs qualify as registered investment companies, and their earnings are not taxed at the corporate level as long as they meet certain provisions, such as the requirement to distribute 90% of their income. Unlike mutual funds and closed-end funds, BDCs also provide some level of direct managerial advice or support to the firms that they invest in. For example, many BDCs will have a seat on the board of directors of their portfolio companies.
To Include or Not to Include Acquired Fund Fees? That Is the Question
A strong case could be made for omitting BDCs' fees from the expense ratios of mutual funds and ETFs. The acquired fund fees and expenses of BDCs are not direct costs borne by the fund. They do not flow through funds' financial statements. Rather, these costs are deducted from the net asset value of the BDC, and as such, they reduce the total return of the fund's investment in the BDC. Acquired fund fees and expenses essentially are a BDC's operating costs, much as the cost of copper is an operating cost for an electronics manufacturer. The difference, however, lies in the way these costs are reported by the funds that invest in these businesses. The cost of copper is not added to the expense ratios of funds that invest in the shares of electronics manufacturers. Likewise, it could be argued that the costs of a BDC should not be added separately to the expense ratio of a fund that owns the BDC. This is especially true for a BDC, which takes an active role in managing the individual companies it invests in, unlike a traditional fund, which is typically a completely passive investor and takes no active role in the day-to-day management of the businesses in which it invests.
Vanguard makes a similar argument in a recent prospectus with "Plain Talk About Business Development Companies and Acquired Fund Fees and Expenses":
A fund may invest in business development companies, a special type of closed-end investment company that generally invests in small, developing, and often private companies. Like an automaker, retailer, or any other operating company, a BDC incurs expenses such as employee salaries. These costs are not paid directly by a fund that owns shares in a BDC, just as the costs of labor and steel are not paid directly by a fund that owns shares in an automaker. SEC rules nevertheless require that any expenses incurred by a BDC be included in a fund's expense ratio as "Acquired Fund Fees and Expenses." The expense ratio of a fund that holds a BDC will need to overstate what the fund actually spends on portfolio management, administrative services, and other shareholder services by an amount equal to these Acquired Fund Fees and Expenses. The Acquired Fund Fees and Expenses are not included in a fund's financial statements, which provide a clearer picture of a fund's actual operating expenses.
Digging Into the Details
The expense ratios listed on Morningstar's quote pages are taken from annual reports in the case of mutual funds and from the most recently filed prospectuses in the case of ETFs. The annual report expense ratio is a trailing measure of actual fund operating expenses incurred over the prior fiscal year, while the prospectus expense ratio is an estimate of future costs. The decision to display the prospectus expense ratio for ETFs was driven by the fact that ETFs issue an updated prospectus whenever they change their expense ratio, which has been happening quite often of late. So, for the majority of ETFs, the prospectus number tends to be a better indicator of future fund expenses versus the backward-looking figure from the annual report.
Small-cap index funds' and ETFs' ownership of BDCs will vary depending on the index they track and the makeup of the fund in question. As far as index providers are concerned, CRSP specifically excludes BDCs from its indexes, while Russell and S&P include them in their small-cap benchmarks. Interestingly, some fund providers that follow the exact same index list different estimates for acquired fund fees. For example, both iShares Russell 2000 ETF (IWM) and Fidelity Spartan Small Cap Index Advantage (FSSVX) follow the Russell 2000 Index, but iShares lists its acquired fund fees and expenses at 0.04% while Fidelity lists them at 0.10%. The figures differ because they are estimates and not actual dollars being deducted from the funds.
The discrepancy between the annual report and prospectus expense ratios explained by BDC-related acquired fund fees can range from modest to massive. For example, iShares Russell 2000 ETF lists a prospectus net expense ratio of 0.24%, including 0.04% of acquired fund fees. However, the actual fees charged by the fund per its latest annual report amounted to 0.20% of fund assets. An extreme example of these fees' influence on reported expenses is Market Vectors BDC Income ETF (BIZD). This fund follows an index composed exclusively of BDCs. The fund's management fee is 0.40%. Meanwhile, acquired fund fees amount to 7.93% of fund assets. This fund has not yet been in existence long enough for it to have issued an annual report, but when it does, the annual report net expense ratio is likely to be a whole lot closer to 0.40% than 8.33%.
We have included a table below that outlines the BDC exposure, acquired fund fees, management fees, prospectus expense ratios, and annual report expense ratios for some of the most popular small-cap ETFs and index funds as well as the Market Vectors BDC Income ETF, which invests solely in BDCs. In the realm of small-cap ETFs and index funds, investors should be mindful that the inclusion of BDCs in these portfolios potentially could cloud fee-level comparisons.
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