Exchange traded funds that cover small-capitalization equities may include exposure to business development companies. However, investors should not be intimidated by the higher “prospectus expense ratio.”

According to Securities and Exchange Commission regulatory rules, funds are required to include in their prospectus expense ratio the pro-rata – a fraction every shareholder is assigned equal to the proportion for each share he or she owns – share of any expenses from investments in other funds, writes Michael Rawson for Morningstar.

Essentially, an ETF comprised of other funds has to list the expense ratio of the underlying funds, along with the management fee tacked onto the ETF itself.

Business development companies invest in private companies or thinly traded public companies and are registered as a type of closed-end funds. Additionally, BDCs also provide some direct managerial advice or direction in selecting investment opportunities.

Since BDCs are a type of fund, any ETF that holds BDCs will be required to list the BDCs’ managerial expenses, or “acquired fund expenses,” along with the ETF’s expense ratio as the net expense ratio.

However, small-cap ETFs with BDC exposure do not directly bear the cost of BDCs. Rawson points out that the acquired fees do not flow through the funds’ financial statement. Instead, BDC fees are subtracted from the net asset value of the BDC, diminishing the total return of the ETF’s investment in the BDC.

“Like an automaker, retailer, or any other operating company, a BDC incurs expenses such as employee salaries,” according to Vanguard. “These costs are not paid directly by a fund that owns shares in a BDC, just as the costs of labor and steel are not paid directly by a fund that owns shares in an automaker. SEC rules nevertheless require that any expenses incurred by a BDC be included in a fund’s expense ratio as ‘Acquired Fund Fees and Expenses.’ The expense ratio of a fund that holds a BDC will need to overstate what the fund actually spends on portfolio management, administrative services, and other shareholder services by an amount equal to these Acquired Fund Fees and Expenses.”

Small-cap ETFs with BDC exposure:

  • iShares Russell 2000 ETF (NYSEArca: IWM): 1.2% in BDCs; acquired fund expense 0.04%, management fees 0.2%, prospectus net expense ratio 0.24%
  • iShares Core S&P Small-Cap ETF (NYSEArca: IJR): 0.4% in BDCs; acquired fund expense 0.03%, management fee 0.14%; prospectus net expense ratio 0.17%
  • Market Vectors BDC Income ETF (NYSEArca: BIZD): 100% in BDCs; acquired fund expenses 7.93%; management fees 0.40%; prospectus net expense ratio 8.33% [Private Equity ETFs Offer Investors Robust Yields]

For more information on BDCs, visit our business development companies category.

Max Chen contributed to this article.

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