Acquired Fund Fees and Expenses: What They Are and How They Work

Mutual funds and exchange-traded funds (ETFs) that invest in other funds often incur additional costs beyond their standard expense ratios. These costs, known as Acquired Fund Fees and Expenses (AFFE), can impact overall investment returns but are not always well understood by investors.

Because AFFE represent indirect expenses, they must be disclosed to ensure transparency for shareholders. Understanding how these fees work is essential for evaluating the true cost of an investment.

Reporting Requirements in Disclosure Documents

Investment companies must follow SEC rules when disclosing Acquired Fund Fees and Expenses (AFFE) in regulatory filings. These costs must be included in a fund’s prospectus and shareholder reports to give investors a complete picture of total expenses. Form N-1A, which governs mutual fund and ETF disclosures, requires AFFE to be incorporated into a fund’s overall expense ratio so investors can see the full impact of these indirect costs.

Funds must report AFFE separately in the fee table of their prospectus under the “Annual Fund Operating Expenses” section. This prevents misleading expense ratios that might otherwise exclude the costs of underlying investments. Even though a fund does not directly pay these fees, they are reflected in the total expense structure to ensure transparency, particularly for funds of funds, which could otherwise obscure the true cost of ownership.

Beyond the prospectus, AFFE must also be disclosed in annual and semi-annual reports filed with the SEC. These reports provide a breakdown of fund expenses, including management fees, distribution costs, and acquired fund expenses. Investors can review these documents to assess how much of their returns are reduced by indirect costs. The SEC’s EDGAR database provides public access to these filings, allowing investors to compare AFFE across different funds.

Calculation Steps

Calculating AFFE involves aggregating the indirect costs from investments in underlying funds. This starts with identifying the portion of a fund’s assets allocated to these holdings, as expenses are proportional to the invested amount. Each acquired fund discloses its own expense ratio in regulatory filings, which serves as the basis for determining its impact on the investing fund’s overall costs.

Once the acquired funds’ expense ratios are known, they must be weighted according to the percentage of assets allocated to each. For example, if a mutual fund invests 40% of its assets in an ETF with a 0.50% expense ratio and 30% in another fund with a 0.75% expense ratio, the weighted costs are calculated by multiplying these percentages by their respective fees. The sum of these weighted figures represents the total AFFE incurred by the investing fund.

To integrate AFFE into the total expense ratio, the weighted acquired fund fees are added to the direct operating expenses of the investing fund. This combined figure provides a clearer view of the total costs borne by shareholders. However, AFFE is not an additional charge deducted from fund assets; it is an indirect expense that reduces overall returns. The SEC’s methodology ensures that investors can compare funds on an equivalent basis without misleading cost disclosures.

Components That Are Typically Included

Acquired Fund Fees and Expenses (AFFE) consist of indirect costs that arise when a mutual fund or ETF invests in other funds. These expenses are embedded within the acquired fund’s operations and passed through to investors. The three primary components of AFFE are advisory fees, transactional charges, and administrative expenses.

Advisory Fees

Investment management fees make up a significant portion of AFFE, as they compensate the acquired fund’s portfolio managers for overseeing asset allocation, security selection, and risk management. These fees are expressed as a percentage of assets under management (AUM) and vary based on the fund’s strategy. Actively managed funds often have higher advisory fees, sometimes exceeding 1.00% of AUM, while passive index funds typically charge lower rates, often below 0.20%.

For funds of funds, these advisory fees compound, as both the investing fund and the acquired fund impose management charges. This layering effect increases total expenses, which is why the SEC requires AFFE disclosure in Form N-1A. Investors should assess whether the additional management expertise justifies the added cost. For example, if a fund of funds has a direct advisory fee of 0.75% and invests 50% of its assets in a target-date fund with a 0.60% advisory fee, the weighted impact on AFFE would be 0.30% (50% × 0.60%).

Transactional Charges

Trading costs incurred by the acquired fund also contribute to AFFE, as they affect the fund’s net asset value (NAV) and, consequently, investor returns. These costs include brokerage commissions, bid-ask spreads, and market impact costs from buying and selling securities. Actively managed funds tend to have higher trading expenses due to frequent portfolio rebalancing, whereas index funds generally experience lower turnover and reduced transaction costs.

Regulatory filings such as Form N-PORT provide insights into a fund’s trading activity, including portfolio turnover rates, which can indicate transactional charges. A high turnover rate—typically above 100%—suggests significant trading activity, which may lead to elevated AFFE. For instance, if an acquired fund incurs $500,000 in trading costs on a $100 million portfolio, the impact on AFFE would be 0.50% ($500,000 ÷ $100 million). Investors should consider whether the potential for higher returns justifies these additional costs, particularly in actively managed strategies where frequent trading can erode net performance.

Administrative Expenses

Operational costs related to fund administration, compliance, and shareholder services also contribute to AFFE. These expenses cover recordkeeping, legal and regulatory compliance, audit fees, and custodial services. While generally lower than advisory fees, they can still be significant, particularly for funds with complex structures or extensive reporting requirements.

Funds that invest in international securities may incur higher administrative costs due to foreign tax compliance, currency hedging, and additional regulatory filings. The Investment Company Act of 1940 mandates that funds disclose these expenses in shareholder reports, allowing investors to assess their impact. If an acquired fund’s administrative expenses amount to 0.15% of AUM and the investing fund allocates 40% of its assets to this fund, the weighted contribution to AFFE would be 0.06% (40% × 0.15%). Investors should review these costs in the context of the fund’s overall expense structure to determine whether they align with the expected benefits of diversification and professional management.

Distinctions From Fund-Level Expense Ratios

Acquired Fund Fees and Expenses (AFFE) differ from standard fund-level expense ratios in how they impact performance reporting and investment analysis. While both represent costs borne by shareholders, AFFE reflects embedded expenses from underlying funds rather than direct charges deducted from the primary fund’s assets. This distinction is particularly relevant when comparing funds of funds to single-layered investment structures, as the latter report only their own operating costs.

A key implication of AFFE is its effect on performance benchmarking. Traditional expense ratios measure a fund’s efficiency by detailing the percentage of assets consumed by management and operational expenses. AFFE, however, can inflate total expense figures, even when the underlying funds generate positive net returns. For instance, a multi-asset fund investing in low-cost index ETFs may report a higher total expense ratio due to AFFE, despite its cost-efficiency relative to actively managed peers. Investors must account for this when assessing cost-effectiveness.