Which CEF Management Fees are most misleading?

Summary: The incorrect but common understanding of Closed End Fund (CEF) costs is that there is a base Management Fee of 1-1.5% of "Net Assets" and some also have an annual Performance Fee (usually 15-20% of any returns above a suitable benchmark). Performance Fee traps need a detailed post on their own (e.g. for now, see TEK). In this post, I focus solely on base Management Fees, and which CEFs appear to have much lower ongoing costs than they actually do. There are many hidden ways to exploit investors: not include GST, charge fees on amounts higher than the proper Net Asset base (excludes leverage and deferred tax assets), place other costs in separate expense categories, have much higher ongoing Total Expense Ratios (TERs) than the Management Fee, and not ever publish TERs. Some CEFs even have expenses that are buried in Notes but not listed in the Income statement. Not a single ASX CEF ever publishes the actual calculation of its Management Fee or Performance Fee (e.g. in its Annual Report). The only solution is to review Annual Reports and calculate expense ratios directly.

Hiding in the CEF fog are a litany of ongoing expenses

Details:

1. What is a Management Fee? Does it cover all active management expenses?

See: > Investopedia - What is a Management Fee?

The management fee is the cost of having your assets professionally managed. The fee compensates professional money managers to select securities for a fund’s portfolio and manage it based on the fund’s investment objective. Management fee structures vary from fund to fund, but they are typically based on a percentage of assets under management (AUM)

In ASX CEFs, the Management Fee and any Performance Fee need to be disclosed (in the Prospectus, PDS, Annual Report, etc) and they are the easiest numbers for firms providing CEF research to report on too.

The Management Fee is just the direct ongoing percentage-based charge by the fund manager. It's usually 1-1.5% and is typically quoted excluding GST.

However, in the vast majority of cases, this severely understates the true Ongoing Expenses which includes all the other operating costs of the fund, whether a LIC or LIT.

The Management Fee is just one of many expenses (investment manager compensation), it does not cover most expenses, even though this is often implied by the self-serving way CEF costs are marketed, and the lazy, incompetent way they are published by "research" firms.

2. The actual expenses of Active Management are extensive, especially in LICs

These other operating costs include: administration, compliance, marketing, shareholder services and all of the costs of being ASX-listed (Listing costs, Director fees, Audits, etc).

An example of the litany of these ongoing expenses is revealed in WAM Strategic Value's (WAR) recent IPO:

WAR's prospectus published a Management Fee of 1% (plus GST) but had no percentage estimate of other ongoing expenses. WAR's FY2021-22 other expenses turned out to be ok (it's over $200m in Net Assets so it can absorb fixed costs), but for many smaller funds the TER (excluding Performance Fees) quickly gets above 3%.

3. Actual Ongoing Expense Ratios vs Published Management Fees

Independent Investment Research (IIR) publishes regular reports of all ASX CEFs with their Management Fees. Below, I've used the FY2021-22 Annual Reports to put alongside the actual Ongoing Expense Ratio for the Australian Mid/Small Cap sector. (Note: These aren't the only CEFs with severely understated costs. I've simply chosen this sector for this post).

The Ongoing Expense Ratio = All Expenses except Performance Fees / Net Assets (excluding Deferred Tax Assets). I refer to this as the Total Expense Ratio (ex Performance Fees).

In the below examples, you can see the actual Total Expense Ratio (excluding Performance Fees) is multiples of the Management Fee. The reasons are:

- Some IIR fees are just incorrectly listed as zero
- All IIR published fees exclude GST
- Fixed costs overwhelm small CEFs, particularly LICs
- Many CEFs charge the Management Fee on Gross Assets or Net Assets inflated by Deferred Tax Assets (i.e. tax losses)
- Some CEFs use leverage and these costs are significant
- Unusual expenses appear. E.g. ACQ has "Earn Out Consideration" costing 0.6%
- The litany of operating expenses, especially for LICs, all adds up

Naos Absolute Opportunities (NAC) was a standout with a TER (ex Performance Fees) of 7.3%!!

An examination of its 2021-22 Annual Report shows a litancy of operating expenses adding up. However, there are two major contributors: Interest expense at 2.36% and Management fees (listed as 1.75% ex GST) actually being 3.46%.

Many ASX CEFs start to shrink because of their high TERs combined with high dividend/distribution levels. This often spirals into very sub-scale funds that are incredibly cost-inefficient. These funds then borrow to pump up their portfolio size but this only expands their TERs!

The biggest reveal of NAC's TER are the actual Management Fees of $1.4m on Net Assets (minus Deferred Tax Assets of $2.3m) of $40.8m.

1.75% plus 10% GST is 1.925% - an extremely high Management Fee expense given Performance Fees also apply. But this is charged monthly on the gross value of the portfolio. As ASX CEFs never detail these calculations it's uncertain what this gross value means, but it could well include the ~$17m in borrowings (an extra 42% of the Net Assets I calculated at 30 June 2022!).