Pull up a list of closed-end funds next to a list of bond ETFs and the expense ratios look like they come from different universes. Plenty of core bond ETFs charge a few hundredths of a percent. Many leveraged closed-end funds report total expenses of 2%, 3%, or even higher. For investors who’ve spent the last decade learning that low fees matter, that can look like a reason to walk away.
Sometimes it is. But a closed-end fund’s reported expense ratio bundles together costs that are very different in nature, and some of what shows up there isn’t a fee in the way most investors think of one. Reading the number correctly takes a few minutes and can change how you compare funds.
The first thing to understand is that a CEF’s expense ratio is expressed as a percentage of net assets attributable to common shareholders, but many of the costs are driven by total managed assets, which include the borrowed money. That difference alone inflates the headline number for any fund using leverage.
A simple example makes this clearer. Imagine a fund with $100 million in common shareholder equity that borrows another $40 million, giving it $140 million in total managed assets. If the adviser charges a management fee of 1% on managed assets, the fee comes to $1.4 million a year. As a share of the $100 million that belongs to common shareholders, that’s 1.4%, even though the stated fee rate is 1%. The fund didn’t hide anything. The leverage just changes the denominator.
The second and usually larger piece is interest expense. When a closed-end fund borrows, whether through a bank credit facility, reverse repurchase agreements, or other structures, the cost of that borrowing is typically reported as a fund expense. In the example above, if the fund pays 5% on its $40 million of borrowings, that’s $2 million a year, or another 2% of common net assets. Add in administrative, custody, and other operating costs, and a fund with a perfectly reasonable 1% management fee can report total expenses above 3.5%.
Here’s why that distinction matters. Interest expense isn’t money going to the manager. It’s the cost of the leverage that produces a big share of the fund’s income. The fund borrows at one rate and invests at a higher one, and the spread flows to common shareholders. Judging the fund purely on total expenses is a bit like judging a rental property only by its mortgage payment without looking at the rent.
That said, interest expense is still a real cost, and it’s worth watching closely right now. Many funds borrow at floating rates tied to short-term benchmarks. The Fed’s rate increase last week pushed its target range to 3.75% to 4%, and officials signaled more hikes may be coming. For funds without hedges or fixed-rate borrowing, the interest expense line is likely heading up over the next several quarters, which narrows the spread between what the fund earns and what it pays to borrow. That’s a direct pressure on net investment income and, eventually, on distribution coverage.
The third category that can distort comparisons is acquired fund fees and expenses. If a closed-end fund invests in other funds, including other CEFs or business development companies, the expenses of those underlying funds are reported as part of the top-level fund’s total expense ratio. Funds that hold a meaningful allocation to BDCs can show strikingly high expense figures for this reason, even though those costs are already reflected in the returns of the underlying holdings.
So how should you actually compare funds? A few approaches tend to work better than looking at the total expense ratio in isolation.
Start by separating the management fee from everything else. Check whether it’s charged on net assets or managed assets, and calculate what it works out to as a share of common equity. That tells you what the adviser is actually being paid.
Then look for the expense ratio excluding interest expense, which most fund reports disclose. That figure gives you a cleaner view of operating costs and makes comparisons across funds with different leverage levels more meaningful.
Next, look at the cost of leverage itself. What rate is the fund paying, is it fixed or floating, and are there any interest rate hedges in place? Two funds with identical leverage ratios can have very different sensitivity to the current rate cycle depending on how their borrowing is structured.
Finally, and most importantly, look at returns on NAV after all expenses. The total return on net asset value over several years already reflects every fee, every dollar of interest, and every underlying fund cost. If a fund with a 3% expense ratio has consistently delivered better NAV total returns than a similar fund charging 1.5%, the higher cost has been earning its keep. If it hasn’t, the expense ratio is telling you something important.
It’s also worth checking for fee waivers and when they expire. Some funds temporarily cap expenses, and the reported ratio may jump once the waiver ends.
None of this means closed-end fund fees don’t matter. They matter a lot, particularly in fixed income, where the difference between a good and a mediocre result can be a percentage point or two a year. But the right question isn’t whether a fund’s expense ratio is high compared with an index ETF. It’s whether the fund’s structure, leverage, and management are producing enough return to justify the costs of running it, and whether the current rate environment is making that harder.
