I love mutual funds for their simplicity and accessibility. Since the first mutual fund was launched in 1924, mutual funds have allowed millions of people to participate in the capital markets, which otherwise would not have had the opportunity.
Mutual funds come in two types – open-end funds and closed-end funds. An open-ended fund continuously offers new shares to the public. When investors want to invest in an open-ended fund, the fund company issues new shares based on the fund’s net asset value. Most mutual funds are open-end funds.
In contrast, a closed-end fund raises money from investors by issuing limited shares in an IPO, much like a public company. After the IPO, the funds are “closed” and the managers invest the funds raised. Since the fund is closed-ended, managers do not need to worry about redemptions from the fund. Therefore, closed-end funds are often used to improve their returns. Shares of closed-end funds trade like stocks.
Despite my love for mutual funds, I know they can be treacherous territory for the average investor. To keep yourself on solid footing, your research needs to go deeper than looking at historical performance. You should understand the fund’s investment strategy, how the fund operates and how the managers are paid. The insights you gain from your research will help you determine whether the managers are really looking for your interests or are simply trying to find you with an attractive sales pitch.
It may seem a little intimidating at first, but a good source of information about a fund is the fund’s filing with the Securities and Exchange Commission, including the fund’s prospectus and “statement of supplemental information,” or SAI. These documents explain a fund’s investment objectives, strategies and operational details. You can usually find copies on the fund company’s website. A careful examination of these documents can tell you a lot about whether the fund manager is doing the right thing for investors.
A good place to start evaluating a fund is its expense ratio. The expense ratio measures the ratio of a fund’s net asset value to paying operating expenses. The largest of these expenses is usually the administrative fee, but the expense ratio can include 12b-1 fees and various legal and administrative expenses. If a closed-end fund uses leverage, the expense ratio is increased by the interest expense incurred by the fund.
A client recently asked me to review the FS Credit Opportunities Fund (ticker: FSCO ), a closed-end fund focused on investments in the bond market. The fund has $2 billion in assets and is 40% leveraged.
I found a copy of the fund’s management agreement in the SEC filings posted on the fund’s website. In the “Advisor’s Compensation” section, “The base management fee is calculated at an annual rate of 1.35% of the fund’s average daily net assets.” I read.
The annual management fee of 1.35% is very high for a fixed income fund. But what really caught my eye is that the fee is calculated based on the total assets of the fund. In other words, the fund not only charges a management fee for the investor’s money, but the fund also charges a fee on the money it borrows. Since FSCO borrows 40% of its total assets, the effective payout to shareholders is 2.25% per annum. The manager uses this leverage to extract an additional $10.8 million in annual fees from the fund’s investors.
In addition, FSCO charges an incentive fee equal to 10% of the fund’s earnings as long as investors first earn at least 1.50% of the fund’s net assets per quarter. Incentive payments are fine by me, but they should be paid to reward exceptional performance. However, FSCO’s leverage means the manager starts earning an incentive fee when the portfolio’s total quarterly return exceeds just 1.07%, or 4.25% annually – an extraordinary performance for the risks the fund takes.
My conclusion was that FSCO is not a fund to buy. The investment strategy may be good, but the managers definitely do not want their investors.
Steven C. Merrell is the owner of Monterey Private Wealth Inc., an independent wealth management firm in Monterey. He is a partner. Receives inquiries regarding investments, taxes, retirement or estate planning. Send your questions to Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them at [email protected]