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Why Closed End Fund Expenses Matter

· Many investors believe that if a fund has produced good total returns, then the funds expenses should not be a factor in your investment decision.

· Their argument is that total return are measured net of expenses so why should expenses matter.

· Here is why I believe expenses matter.

If I could buy funds past returns: then buying the funds with the highest total returns without worrying about fund expenses would be a very good strategy. However, when investing in a fund we are buying their future returns, we are only looking at past total returns to help us predict future returns. The thinking is that a fund that has proven it can out perform in the past will continue to outperform in the future.

If past performance were totally dependent on management skill than investing would be easy. Find the fund managers with the best total returns in the past and retire to Miami. However, it is not that easy because total returns are not based entirely on management skill. There are two other factors that contribute heavily to total returns:

  1. The amount of risk management is assuming
  2. Luck

We have been in a sustained bull market in many asset classes. In such a market managers who take on additional risk are going to outperform more often than not. Outperformance generated from risk is not an indicator of management skill and those funds that outperform based on risk stand a better chance of returning outsized losses under other market conditions.

As a member of the Seeking Alpha community I can be sure that when I achieve above average market returns, it is based entirely on skill (Tongue Firmly Planted In Cheek). However some fund managers may not have my acumen. Some of their success may be attributed to dumb luck.

Because we cannot count on luck to continue we are only looking for managers that can outperform based on skill. We want to find managers that are skilled enough that they can consistently not only outperform the market but outperform it by enough that even after paying themselves there will be enough left over to pay their investors better than market returns, or at least better returns then competing funds.

There is a lot of research that indicates that because of the amount of luck involved past outperformance is a poor indicator of future outperformance, especially when the outperformance has not occurred over a very long period of time. Many believe it is so difficult to find active management that will outperform the market based on skill that one should just index. (Larry Swedroe and other SA authors have written extensively about this and I believe provide a useful viewpoint.)

If you are reading this you are probably an active investor and believe it is possible to select managers that will outperform the market. You probably also believe that past performance can be used to help select these managers. However, do you believe that all outperformance can be attributed to skill? When using total returns as a guide you are assuming that at least some of the above average total return generated by management was based on skill. Sometimes you are going to be totally incorrect and management is no better or even worse than average. Sometimes management is actually better than average but not as good as their past total returns.

Expenses on the other hand are more definitive. Any money management is paying itself or spending on nice executive suites is money coming directly out of your pocket. I am not discussing the interest expenses associated with leverage. However, it should be noted that most funds calculate their management fees on total assets not just NAV so the amount of leverage has an impact on the management fees.

If a fund has a 2% expense ratio while other funds in the category have a 1% expense ratio, that extra expense is coming directly out of your pocket. If an average fund in the category is earning 10% on NAV and 9% after expenses, than the fund charging 2% needs to earn 11% just to return have same total return after expenses. Earning 10% more then the competitors on a consistent basis is a high hurdle to clear on a consistent basis.

It gets worse when market returns are less favorable. If the average fund in the category is returning 5% on NAV before expenses with 1% percent fee the return on NAV to investors is 4%. The fund manager charging 2% in fees will need to return 6% on NAV before expenses to match his competitors, that is they need to generate 20% more income than their competitors, a very high hurdle.

On the other hand if the average fund in a category has income of 20% before expenses and 19% after, then the fund that charges 2% in expenses has to earn 21% before NAV to match the competitors, only 5% more. This is why the cost of expenses is less noticeable in a strong bull market, a manager has to be only slightly more skilled or luckier than his competitors to overcome the handicap of high expenses. I believe this is why in our current bull market investors are not paying enough attention to expenses.

IN CONCLUSION

  1. A funds past outperformance will predict future outperformance only to the degree that risk-adjusted outperformance was based on skill.
  2. There have been a lot of studies that indicate luck plays a large factor in performance.
  3. In a bull market high expenses have less of an impact on total return and are often overlooked.
  4. Unless you believe that you can predict future performance with a very high degree of accuracy expenses matter.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.