Why Understanding CEF Fee Structure Is A Source Of Alpha

Jul. 09, 2020 3:27 AM ETBBN, ECC, GUT, JLS, JPS, PDI, PFF17 Comments

Summary

  • An understanding of CEF expenses can give income investors a serious advantage in the market.
  • We discuss common misconceptions such as conflating interest expense and management fees or using stale interest expense figures.
  • One key takeaway is that understanding the cost structure of a given CEF's leverage instrument is essential for gauging distribution stability.
  • Looking for a helping hand in the market? Members of Systematic Income get exclusive ideas and guidance to navigate any climate. Get started today »

Aspects of the CEF market can be daunting and non-transparent to all but its die-hard followers. A number of misconceptions that we see again and again in comments have to do with fund fees and expenses. In this article, we talk about some of the key fees, charges or expenses that investors face when transacting and holding CEFs. In the article, we take a broad view of costs including both investor and fund-level trading and execution considerations alongside the more familiar fund charges like management fees and interest expense.

One key takeaway is that an understanding of the fund expense structure can give income investors a serious advantage in the CEF market by being able to forecast earnings trends and distribution coverage. Investors should also be aware of common misconceptions such as treating fund expenses as management fees or using stale interest expense figures.

Personal Costs

In this article, we take a holistic view of all the potential types of costs faced by investors in transacting and holding CEFs. This is why it is important not to ignore the costs of transacting in the CEF which can vary hugely. Personal charges can be split into explicit and implicit types. Explicit costs are those charged by the brokerage in the form of commissions (currently zero for most big players) and exchange fees (should be tiny).

Implicit costs are the bid/offer costs of any given fund or the potential opportunity cost foregone for investors using limit orders to transact. An indicator of this is the daily average volume shown in the chart below for the multi-sector CEFs. These can vary hugely between funds depending on their size and investor interest. Using market orders is generally a bad idea in CEFs. Using limit orders can be a good idea though investors have to be careful they don't find themselves on the wrong side of a trend - for instance setting a limit buy order of 0.5% below the last close prior to the market open when the S&P 500 futures are pointing to a -3% open can be a bad idea, particularly for less liquid funds.

Source: Systematic Income, Tiingo

Management / Investment Advisory Fees

Management fees are what people generally mean when they talk about fund fees. These are the fees the fund charges in order to pay its fund managers, support staff as well as make money for the firm.

This sounds easy enough however this is where it gets complicated. Some funds charge a fixed fee on net assets while others do it on total assets. Funds that charge a fee on total assets have an incentive to run the fund at higher leverage since that increases the amount of total assets as well as fees. The presentation of the management fee can also vary with some funds highlighting their total asset fee while others specify a net asset fee.

For example, the PIMCO Dynamic Credit and Mortgage Income Fund (PCI) prominently shows a management fee of 1.15% as the first line of its Fees & Expenses section on the fund website. However, this fee is charged on total assets and with total assets being nearly twice net assets, it means that the management fee levied on investors' capital is just north of 2%. The fund does not disclose its management fee on net assets though it's not a million miles away from the second row in the table on their site.

Source: PIMCO

BlackRock does something different. For example, the BlackRock Taxable Municipal Trust (BBN) shows that it levies a management fee against total assets however, confusingly, the management fee shown on its website is a fee on net assets - the fund's fee on total assets is actually 0.55%.

Source: BlackRock

Some funds choose to waive management fees for a certain period of time for various reasons. For example, the Nuveen Mortgage and Income Fund (JLS) has a fee waive schedule from 1.5% to 0.25% on total assets for 12 months after the completion of its restructuring in late 2019.

Another thing to watch out for, though it's not very common, is incentive fees. For example, the Eagle Point Credit Company (ECC) has an incentive fee schedule based on the previous quarter's net investment income. This meant that in 2019 the fund earned an incentive fee of about 2.8% on net assets in addition to its 1.75% management fee on net assets.

The takeaway of this section is to pay attention to whether the management fee figure you see on the fund's website is charged on net or total assets. The 1940 Investment Company Act specifies that funds have to disclose gross expense ratios, however, these include interest expense as well which makes it difficult to compare apples-to-apples since CEFs use different levels of leverage.

Fund Expenses

There is a set of fund expenses that are necessary to run the fund but that does not go to the fund company. These are things like accounting, printing, custodian, trustee, legal, audit and other fees. These are usually on the order of 0.1-0.4% on net assets.

Another set of fund expenses is acquired fund fees, particularly for funds of funds but also for funds that choose to source a small amount beta exposure in the form of open-end funds, particularly in money market holdings. This means that funds of CEFs whether ETF or CEF themselves incur two layers of management fees, the first by the fund of funds managers and the second by the individual managers of the portfolio funds.

Interest Expenses

CEF interest expenses are often the largest fund expense. Like other fund expenses interest expense is a charge that the fund is charged itself by its leverage provider. While being one of the two largest expenses, interest expense is also one of the hardest to nail down. This is for a number of reasons. First, leveraged CEFs often hold floating-rate leverage instruments so their interest expense changes on a quarterly basis. Secondly, some CEFs choose to hedge their floating-rate leverage instruments though this can be difficult to separate from a duration hedge. Thirdly, fund borrowings can change frequently due to borrowing covenant constraints or manager views. Fourthly, additional fees such as commitment fees or auction agent fees in the case of auction-rate preferreds can further muddy the water.

For investors who care about fund earnings and distribution sustainability, interest expenses are one of the most important factors to consider. In an earlier article, we discussed how different leverage cost structure was one of the drivers of preferred CEF sector distribution divergence between the Flaherty & Crumrine and Nuveen funds.

Source: Systematic Income

To illustrate how important the nature of the leverage facility can be considered a fund with a portfolio yield of 6%, a fee of 1% on total assets, leverage of 35% and a leverage facility on which it pays 1M-Libor + 1%. At the start of 2019, prior to the drop in short-term rates, the fund's net investment income yield would have been 5.8%. At current rates, the fund's yield would be 7.1%. The increase in 1.3% in the fund's yield is due just to the drop in rates on its leverage facility. Of course not all funds have unhedged floating-rate facilities so figuring out which funds stand to benefit the most requires careful individual fund analysis.

In addition to fixed or floating-coupon, leverage instruments also vary by type. The chart below shows rough ranges for different types of leverage facilities. The most common taxable fund facilities are reverse repurchase agreements and credit facilities along with less frequently utilized auction-rate preferreds and senior securities. Municipal funds tend to use tender option bonds, variable-rate municipal term preferreds and auction-rate preferreds.

Source: Systematic Income

Commitment fees are typically used in credit and bank loan agreements and credit facilities as a way to allow the fund to quickly "tap the line" and borrow at quick notice. The cost of such a commitment is usually on the order of 0.15% on the portion of the agreement that is not drawn down.

One thing to watch out for is that senior securities like preferred stock and baby bond payments are not technically considered fund expenses. This means that the net investment income of funds that use these instruments is effectively overstated.

Below is a screenshot of the Gabelli Utility Trust (GUT) cash flow statement which shows total investment income of $10.5m versus total expenses of $4.4m with net investment income being $6.1m. However, this figure ignores the $5.1m of preferreds distribution that the fund has to pay because it has chosen to use this relatively expensive way to raise leverage. Had it used a credit facility, its cost would be included as an expense.

Source: Gabelli

Fund Turnover Costs

Much like individual investors face transaction costs when dealing in CEFs, fund managers face costs when dealing in the underlying securities. The actual costs can be quite variable and dependent on the fund's underlying asset class, amount of trading that the fund does, general market liquidity and other factors.

An important factor that drives fund turnover costs are whether the fund is a liquidity demander or a liquidity provider. In other words, when the fund decides to transact in a given security does it "take the price" or does it "give the price"? Funds with large balance sheets and flexible mandates are more likely to be liquidity providers. They will often get the first call from a bank trading desk or a rival asset manager to see whether they are in position to bid on certain assets. This ability to provide liquidity during difficult time periods can allow the fund to acquire assets at very attractive prices. In effect, this can lead to a negative cost of turnover - meaning the fund can, in effect, act as a market-maker and allow it to earn the bid/offer spread on assets rather than pay it.

Funds that are managed by larger fund families such as PIMCO, Nuveen and BlackRock are in a better position here by virtue of managing a huge amount of assets. They are able to transact in large sizes and then spread the assets across a large number of internal funds.

Fund Expense Misconceptions

In this section, we briefly discuss a number of persistent misconceptions made by some CEF investors.

The first misconception is to confuse fund management fees and fund expenses. For instance, an investor comparing the total expense ratio of 3.02% shown on CEFConnect for the Nuveen Preferred & Income Securities Fund (JPS) against the popular preferreds ETF iShares Preferred and Income Securities ETF (PFF) of 0.46% may conclude that CEF fees are so egregious as not worth the bother. Of course, the bulk of that fee is interest expense which goes to the leverage provider rather than Nuveen. The apples-to-apples comparison is a number of 1.3% for JPS versus 0.46% for PFF.

The second misconception is to ignore the fact that interest expense, which drives the bulk of the optically high fund fee, goes to generate additional yield for the fund. Instead of the focus being on the high interest expense investors should place more focus on how much additional yield does the leverage generates. If we disaggregate the sources of JPS yield we can see that the additional leverage used by the fund generates an additional 2.2% of yield on investor capital net of its cost.

Source: Systematic Income

The third misconception is to use a rearview mirror in evaluating interest expense. For instance, CEFConnect will tell you that the JPS interest expense is currently 1.73%. In fact, this is almost double the fund's real interest expense. The error results in the fact that this interest expense refers back to the period when short-term rates were much higher than they actually are now.

Investor Takeaways

A lack of consistency in disclosure, as well as market driven interest expenses, make it difficult for investors to gauge costs between funds or even in the same fund across different time periods. Apart from digging into the reports of each and every CEF, there are a few rules of thumb that investors can follow.

First, CEFConnect does a reasonable job in providing fund management fees on net assets. However, investors should not use it for interest expense figures which are stale at best.

Secondly, some fund companies do a better job than others in providing disclosures. For example, Nuveen breaks down their fees across different categories including interest expense on both net and total assets. For PIMCO CEFs investors should look at the second row of the Fees & Expenses section to gauge fund fees and expenses ex-leverage on net assets. BlackRock funds show management fees on net assets, though confusingly they imply that it is a total asset figure.

Thirdly, municipal sectors by-and-large use floating-rate leverage instruments which means that they will take full advantage of the drop in short-term rates. This, in part, explains why the sector has seen the largest number of distribution increases in the last few months. PIMCO funds, both municipal and taxable, also use floating-rate leverage instruments.

Fourthly, to more accurately forecast fund earnings and distribution sustainability investors have to understand the fund's leverage structure. Funds with unhedged floating-rate instruments have been able to benefit from the recent drop in short-term rates while those with hedged or fixed-rate instruments have not.

Finally, when comparing CEF and ETF expenses, rather than focusing on the headline figures it makes sense to gauge how much additional yield the CEF is generating from its use of leverage.

An understanding of CEF expenses may look like one of the least interesting or relevant parts of income investing. However, a firm grasp of some of the key concepts can give investors a serious advantage in the market.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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