Staff Responses to Questions Regarding Disclosure of Fund of Funds Expenses
The staff of the Division of Investment Management has prepared the following responses to certain questions raised in connection with amendments to the fee table adopted in the Fund of Funds release in June 2006.1 These amendments require funds to disclose in their fee tables the expenses of investing in other funds under a line item titled “Acquired Fund Fees and Expenses” (“AFFE”).
These responses represent the views of the staff of the Division of Investment Management. They are not a rule, regulation, or statement of the Securities and Exchange Commission, and the Commission has neither approved nor disapproved this information.
All responses refer to Item 3 of Form N-1A, but apply equally to similar items in Forms N-2 and N-3.
Q: Instruction 3(f)(i) to Item 3 of Form N1-A requires a fund that invests in other funds (Acquired Funds) to disclose the fees and expenses associated with those investments. An “Acquired Fund” includes any company that would be an investment company under section 3(a) of the Investment Company Act but for the exceptions to that definition provided in sections 3(c)(1) and 3(c)(7) of the Act. In addition to hedge funds and other pooled investment vehicles discussed in the Adopting Release, some structured finance vehicles, such as collateralized debt obligations, may rely on section 3(c)(1) or 3(c)(7) of the Act. Must their expenses be included in an acquiring fund’s fee table?
A: No. AFFE is intended to include the expenses of investments in investment companies, hedge funds, private equity funds, and other entities traditionally considered pooled investment vehicles. Accordingly, the staff would not recommend enforcement action if a fund does not include in the fee table expenses associated with investments in structured finance vehicles, collateralized debt obligations, or other entities not traditionally considered pooled investment vehicles.
Q: Must an Acquiring Fund include in its calculation of AFFE, expenses the Acquired Fund incurred through its investment in other investment companies?
A: No. Instruction 3(f)(iv) to Item 3 of Form N-1A provides that the total annual operating expense ratio used for purposes of calculating AFFE is the annualized expense ratio disclosed in the Acquired Fund’s most recent shareholder report. This expense ratio does not include expenses an Acquired Fund has incurred through its investment in other companies. (See question 3, however, with respect to disclosures for feeder funds.)
Q: Are feeder funds required to include the AFFE in their prospectus fee tables?
A: Yes. Open-end feeder funds filing on Form N-1A must disclose in their fee tables the aggregate expenses of the feeder fund and the master fund (see Instruction 1(d)(i) to Item 3 of Form N-1A). The Form N-1A requirement pre-dates the new fund of fund disclosure amendments and has not been changed; the Commission added a similar Form N-2 requirement (see Instruction 10.h to Item 3 of Form N-2).
Q: Instruction 3(f)(iv) to Item 3 of Form N-1A states that the annual operating expense ratio to be used for purposes of calculating AFFE is the ratio disclosed in an Acquired Fund’s most recent shareholder report. Does “most recent” refer to the report available as of the Acquiring Fund’s fiscal year end or as of the date of the Acquiring Fund’s prospectus update in which the AFFE information will appear?
A: The term “most recent” refers to the Acquired Fund’s shareholder report available at the time the Acquiring Fund calculates the AFFE. The Acquiring Fund should use the Acquired Fund’s required expense ratio presented in the financial highlights table contained in the most recent annual or semi-annual report when the Acquiring Fund calculates the AFFE. If the semi-annual report is the most recent report, however, the Acquiring Fund must use an annualized expense ratio (see footnote 78 of the Adopting Release and accompanying text).
Q: Instruction 3(f)(ii) to Item 3 of Form N-1A sets forth the formula for AFFE, which includes a calculation of the daily expense ratio and the number of days invested in an Acquired Fund. Should weekend days be included in these elements of the AFFE?
A: Yes, except for the calculation of average invested balance.
Daily Expense Ratio. The numerator in the AFFE formula includes a calculation of the daily expense ratio where “F” is the total annual expense ratio for each acquired fund and “FY” is the number of days in the fiscal year. Because F is an annualized expense ratio, FY must be either 365 or 366 days. Therefore, for purposes of calculating the daily expense ratio, weekend days must be included.
Average Invested Balance and Number of Days Invested in each Acquired Fund. The numerator in the AFFE formula also includes a calculation of average invested balance (“AI”) in each acquired fund and the number of days invested in each Acquired Fund (“D”). Average invested balance is calculated based on, at a minimum, the monthly investment balance in the Acquired Fund. Therefore, average invested balance can be calculated using daily, weekly or monthly investment balances. The number of days invested is calculated using calendar days, which includes weekends (see Instruction 3(f)(v) to Item 3 of Form N-1A).
Q: Instruction 3(f)(v) to Item 3 of Form N-1A states that the numerator for calculating average invested balance (“AI”) for purposes of AFFE, is the amount initially invested in the Acquired Fund during the most recent fiscal year plus the amounts invested in the Acquired Fund measured no less frequently than monthly. Are the monthly measurements based on the market value of the investment in the Acquired Fund?
A: Yes. The amounts invested in an Acquired Fund are calculated using the value of the investment in the Acquired Fund as of the measurement date, which would take into account market appreciation (except for money market investments priced at amortized cost) (see footnote 72 of the Adopting Release). For example, if the Acquiring Fund calculates average daily investment in a registered open-end fund, the Acquiring Fund would base the value of that investment on the Acquired Fund’s NAV at the end of each day, which would include any unrealized appreciation or loss with respect to the Acquiring Fund’s investment.
Q: As note above, an “Acquired Fund” includes any company that would be an investment company under section 3(a) of the Investment Company Act but for the exceptions to that definition provided in sections 3(c)(1) and 3(c)(7) of the Act. If an Acquiring Fund lends portfolio securities and invests the cash collateral received in a money market fund or other cash sweep vehicle that meets the definition of “Acquired Fund,” must the Acquiring Fund include the fees and expenses associated with the investment of the cash collateral in the calculation of AFFE?
A: No. Fees and expenses associated with investment of cash collateral received in connection with loans of portfolio securities in a money market fund or other cash sweep vehicle that meets the definition of Acquired Fund do not have to be included in the calculation of AFFE.
Q: If an Acquiring Fund’s investment in an Acquired Fund is a debt rather than equity interest, must the Acquiring Fund include expenses associated with the debt in the AFFE?
A: An Acquiring fund investing in debt must include any transaction fees it paid in connection with acquiring or disposing of a debt interest in an Acquired Fund but not its pro rata portion of the cumulative expenses charged by the Acquired Fund because these expenses do not impact its debt interest in the Acquired Fund. See Instruction 3(f)(ii) to Item 3 of Form N-1A and Footnote 73 of the Adopting Release and accompanying text.
1 Fund of Funds Investments, Investment Company Act Release No. 27399 (June 20, 2006) [71 FR 36640 (June 27, 2006)] (“Adopting Release”). The Release can be found at: http://www.sec.gov/rules/final/2006/33-8713.pdf.