At first glance, the total expense ratios on MDCEX and MDFIX may look high when compared to other open-end mutual funds or exchange traded funds (ETFs). But before you jump to conclusions, we think it’s incredibly important to understand:
- Are expense ratios important when evaluating closed-end funds for investment?
- Why do the expense ratios for MDCEX and MDFIX look high?
- What direct cash expenses are actually incurred by MDCEX or MDFIX shareholders?
Are expense ratios important when evaluating closed-end funds for investment?
Contrary to what most investors assume, our proprietary research indicates that expense ratios are not statistically significant predictors of future total return for closed-end funds. This research conclusion is counterintuitive and goes against most conventional investing wisdom. For open-end mutual funds and ETFs, we believe expense ratios are extremely important in fund selection and are significant predictors of future total return.
So why is it different for closed-end funds?
We have studied, modeled, and tested the closed-end fund market extensively to determine what factors are statistically significant in predicting future total returns for individual closed-end funds (see U of O Study). While it’s hard to believe, expense ratios have virtually no influence on the future returns of individual closed-end funds. When we evaluate closed-end funds for potential investment within MDCEX and MDFIX, we do not consider expense ratios to be important.
Our research indicates that the single most influential factor on future total returns for closed-end funds is a fund’s discount or premium to its net asset value (NAV). A closed-end fund can trade at a price that is different from its stated NAV. When a closed-end fund is trading at a price that is less (more) than its NAV, it’s said to be trading at a discount (premium). Our research indicates that the relationship between price and NAV is highly correlated to a closed-end fund’s subsequent total return. Further, our research shows that more heavily discounted closed-end funds tend to have better subsequent performance than less discounted closed-end funds or those that trade at a premium. This research conclusion forms the core basis of our investment strategies within MDCEX and MDFIX.
Why do the expense ratios for MDCEX and MDFIX look high?
It’s critical to remember that both MDCEX and MDFIX are open-end mutual funds that invest into closed-end funds. By definition, they are both considered to be fund of funds vehicles. Understanding the fees you pay in a fund of funds can be confusing, and the SEC requires that the operating expense of a fund of funds includes the operating expenses of its underlying holdings. These fees are known as Acquired Fund Fees and Expenses (AFFE). If you review the Annual Fund Expenses of MDCEX and Annual Fund Expenses of MDFIX, you will see AFFE as a line item in each table.
For MDCEX and MDFIX:
- AFFE represents the underlying fees and expenses of the closed-end funds we invest into.
- AFFE are not a cash expense to shareholders in our Funds.
- Matisse Capital does not collect any portion of AFFE.
- AFFE do not affect our Funds’ actual operating costs.
AFFE are the primary reason why our Funds’ expense ratios look high in comparison to other investment options. The main takeaway here is that while we are required to include AFFE as a part of each Funds’ total expense ratio, it is not a direct cash expense and it does not represent the direct cash expense paid by an investor in our Funds (more on that below).
What direct cash expenses are actually incurred by MDCEX or MDFIX shareholders?
The cash expense that a shareholder incurs in a mutual fund is known as a direct cash expense. These expenses typically include management fees, 12b-1 fees, and expenses related to the operations of a mutual fund (administration, accounting, compliance, etc.). In a fund of funds, the direct cash expense paid by a shareholder can potentially be much lower than the fund’s total expense ratio. This is true in the case of MDCEX and MDFIX for two primary reasons:
AFFE is not a cash expense of our Funds, yet it contributes the most to each Funds’ total expense ratios (as described above).
Both our funds have provisions in place that set a maximum limit for the direct cash expenses our shareholders pay.
To keep direct cash expenses down, each fund has its own Expense Limitation Agreement in place that caps the total amount of direct cash expenses our shareholders can pay. If you review the Annual Fund Expenses of MDCEX and Annual Fund Expenses of MDFIX, you will see this noted within each table.
We believe the expense cap is the most relevant expense number to consider when evaluating both MDCEX and MDFIX, as any expenses shown above this limit are not actual direct cash expenses incurred by our Funds’ shareholders. In our opinion, the expense cap is a more accurate representation of the fees our shareholders actually pay.
Which leads to an interesting question for MDCEX and MDFIX – does AFFE even matter?
Premises:
- AFFE represents the underlying fees and expenses of the closed-end funds we invest into.
- Our proprietary research indicates that expense ratios are not statistically significant predictors of future total returns for closed-end funds.
Conclusions:
- We believe AFFE are not a statistically significant predictor of the future total returns for the underlying holdings of MDCEX and MDFIX.
- As investors evaluate MDCEX and MDFIX for investment, we think they should consider that AFFE significantly increase our Funds’ Total Annual Fund Operating Expenses and Net Annual Fund Operating Expenses.
To reiterate, our view is that the expense cap for our Funds is the most relevant expense number to consider when evaluating both MDCEX and MDFIX, as this number represents actual direct cash expenses incurred by our shareholders.
On a final note – if you’re still not sure about our Funds’ expenses, consider that all performance and distributions for both MDCEX and MDFIX are shown after all fees and expenses.