BDC Stocks: Acquired Fund Fees and Expenses (AFFE)

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When a mutual fund or ETF invests in a business development company, the BDC’s fees are reported as if they were the fund’s fees. An executive at Apollo Investment Corporation (AINV) argued on that this policy leads to inflated fee that make these funds appear more costly than they really are.

Since its adoption in 2014, this reporting requirement has forced funds that invest in BDCs to vastly overstate their fees and overhead costs to potential investors by as much as 1,600 percent, in one case.

This is known as “acquired fund fees and expenses” or AFFE. The Market Vectors® BDC Income ETF (BIZD) discussed in the article actually charges a net expense ratio of 0.40% on assets. However, because it invests the money in BDC stocks, the BDC ETF must report the fees and expenses that the BDCs pay as expenses of the ETF.

All of the operating costs of the BDCs held by the ETF appear in the ETF’s acquired fund fees and expenses of 8.77%. This ratio is calculated by dividing all of a BDC’s operating expenses (management and incentive fees, board member payments, salaries, interest expense, auditing costs, etc.) and dividing it by the amount of equity at the BDC. The ETF’s manager only gets paid 0.40% for managing the ETF, much less than the reported net expense ratio of 9.17%.

A lot of people don’t like how AFFE affects BDCs but doesn’t affect other yield vehicles or other financial companies. If a fund owns a real estate investment trust (REIT), it doesn’t report the REIT’s expenses as its own. If an ETF holds a bank, it doesn’t report all the salaries and expenses of running the bank as expenses of the fund, too.

Some say AFFE rule has harmed BDC share prices because it restricts institutional ownership. In 2014, BDCs were removed from Russell indexes, and the index funds that use them, because the AFFE rule made Russell indexes that held BDCs look more expensive than they actually were.

SEC regulations related to index funds’ reporting of Acquired Fund Fees and Expenses (“AFFE”) in their prospectus have created a distortive impact on index fund expense ratios. Following consultation with the Russell Index Client Advisory Board and our broader client base, as well as an analysis of applicable regulations, Russell decided that BDCs are ineligible for Russell index membership.

Since ETFs’ low expenses are a major selling point, not many index funds want to hold BDCs if it means having to report a higher expense ratio. Maybe the SEC will revisit AFFE and BDCs, and maybe not. But if AFFE rules are changed, it would be a bullish sign for the BDC industry. BDCs are getting louder about being treated differently.

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