How well do you know your mutual fund?
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 who would never have had the opportunity otherwise. Mutual funds come in two varieties — open-end funds and closed-end funds. An open-end fund continuously offers new shares to the public. When investors want to put money in an open-end fund, the fund company issues new shares to them at the fund's net asset value. Most mutual funds are open-end funds.
A closed-end fund, on the other hand, raises money from investors by issuing a fixed number of shares in an IPO much like a public company. After the IPO, the fund is “closed” and the managers invest the funds that were raised. Because the fund is closed, managers do not have to worry about redemptions from the fund. Consequently, closedend funds often use leverage to enhance their returns. Shares of closed-end funds trade on an exchange much like a stock.
Despite my love of mutual funds, I know they can be treacherous territory for the casual investor. To keep yourself on solid ground, your research needs to go deeper than just looking at historical performance. You need to understand the fund's investment strategy, how the fund works, and how its managers are being paid. The insights you gain through your research will help you determine if the managers are truly looking out for your best interests, or if they are simply trying to cash in on an attractive sales pitch.
It may seem a little daunting at first, but a good source of information about a fund is its filings with the Securities & Exchange Commission, including the fund's prospectus and its “Statement of Additional Information”, or SAI. These docu
ments describe a fund's investment objectives, strategies, and operational details. You can usually get copies on the fund company's website. A careful perusal of these documents can tell you a lot about whether the fund manager is truly working for the investors.
A good place to start your evaluation of a fund is its expense ratio. The expense ratio measures the percentage of a fund's net asset value that goes to pay operating expenses. The largest of these expenses is usually the management fee, but the expense ratio may also include 12b-1 fees and various legal and administrative expenses. If a closed-end fund uses leverage, the expense ratio will be inflated by the interest expense incurred by the fund.
A client recently asked me to research the FS Credit Opportunities Fund (ticker: FSCO), a closedend fund focused on investments in the more esoteric sectors of the bond market. The fund has $2 billion in assets and uses 40% leverage.
In the SEC documents posted on the fund's website, I found a copy of the fund's management agreement. In a section called “Compensation of the Adviser,” I read: “The base management fee shall be calculated at an annual rate of 1.35% of the Fund's average daily gross assets.”
An annual management fee of 1.35% is pretty high for a fixed income fund. But what really caught my eye was that the fee is calculated on the gross assets of the fund. In other words, not only does the fund charge a management fee on investor money, but it also charges a fee on the money the fund borrows. Since FSCO borrows 40% of its gross assets, the effective fee borne by the shareholders is actually 2.25% per year. Using this sleight of hand, the manager extracts an additional $10.8 million in annual fees from the fund's investors.
FSCO also charges an incentive fee equal to 10% of the income produced by the fund as long as investors first earn at least 1.50% in a quarter on the net assets of the fund. Incentive fees are fine by me, but they should be paid to reward extraordinary performance. However, FSCO's leverage means that the manager will start earning an incentive fee when the total portfolio's quarterly income is only 1.07% percent or just over 4.25% per year—hardly extraordinary performance for the kinds of risks this fund takes.
My conclusion was that FSCO is not a fund I would buy. The investment strategy might be fine, but the managers are definitely not looking out for their investors.
Steven C. Merrell is a partner at Monterey Private Wealth Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.