Value of Anti-Market Timer Redemption Fees Questioned
December 22, 2003
(Reprint from 12/9/02 MFMN)
More mutual funds are adding redemption fees to curb market timers.
However, these fees may not be the most effective strategy, according to industry analysts.
"There's more they have to do proactively than just throw a redemption fee on the fund," said Lars Schuster, research analyst for Financial Research Corp., Boston. "Brokers still think they can market time well enough to pay that redemption fee."
Some investment companies, Schuster observed, have assembled internal market-timing watchdogs to identify market timers and negotiate deals with them. They might limit the number of trades, say, to four round-trip trades in a year. Or, they might block them from the funds entirely. That, Schuster said, seems to be more effective than strictly adding redemption fees.
"A few years back, we couldn't find any statistical evidence that [redemption fees] were effective," even though many fund complexes believe they help defray costs to long-term shareholders, added Scott Cooley, an analyst for Morningstar of Chicago.
However, market timers can cause cash flow problems for fund managers.
Despite the questionable value of redemption fees in halting this trend, Cooley said more funds seem to be launching redemption fees. Based on Morningstar data, 1,118 mutual funds out of 14,298, or nearly 8%, charge redemption fees ranging between two basis points to 5%. The average is 1.18%. The period shareholders must hold their shares to avoid the redemption fee ranges from one month to five years.
Regardless of the high 5% fee Morningstar reported, the Securities and Exchange Commission generally limits redemption fees to 2% since mutual fund shares are supposed to be freely redeemable.
However, in a March 7, 2001 SEC no-action letter involving the Fidelity Advisor Korea Fund Inc., the commission allowed for a 4% redemption fee. The mitigating factors that persuaded the SEC included the fact that the fund is a single-country, emerging markets fund converting from a closed-end to open-end format.
"Funds are launched with higher redemption fees. Then someone brings it to the attention of the SEC and they send a letter," Cooley said.
Geoff Bobroff, an East Greenwich, R.I. consultant, said besides curbing market timers, redemption fees are levied to curb arbitrageurs, who typically play off of the different market closings of international funds traded around the globe.
But mutual fund groups are not necessarily levying their redemption fees across the board. Redemption fees are most prevalent on volatile funds. Vanguard of Valley Forge, Pa., for example, only has redemption fees on 14 of its 109 funds. In fact, it actually removed the 1% redemption fees on its strategic equity fund and global equity fund in April 2001.
"The fees had been established at the funds' inception in 1995," said Vanguard spokeswoman Rebecca Cohen, "but disruptive, short-term transaction activity did not emerge as a significant issue."
Vanguard's redemption fees vary, from 50 basis points to 2%. Fees on its tax-managed funds, launched in 1999, are tiered: 2% on shares held less than one year; 1% on shares held more than one year but less than five years.
"The redemption fee policy on these funds has been extremely successful," Cohen said, maintaining that this is "tangible evidence of [the fact that] the tax-managed funds have never paid a capital gain." She attributed this to "the low transaction activity in the funds."
Many of Vanguard's redemption fees were implemented when the funds first were created. But redemption fees also were added to the company's Selected Value and Primecap funds after the funds began attracting hot money.
Third Avenue Funds of New York has fees of 1% on shares held less than one year on its small-cap value fund and real estate value fund. For its international fund, it charges 2% on shares held less than one year. But it has avoided levying a fee on its flagship fund, the Third Avenue Value Fund.
"The international fund is much more expensive to run," explained Joanne Jaffin, Third Avenue Funds director of marketing. As for omitting a fee on its flagship fund, she said the firm historically has never experienced volatility or hot money flowing into that fund.
"We were unwilling to change what has worked in the past," she added.
In fact, Jaffin said she is not sure that redemption fees have ever acted as a deterrent to people who trade in and out of mutual funds. "We've not specifically endeavored to track it. When we have identified market timers, we've contacted them and blocked them."
Five of Boston-based Oakmark's seven funds have charged 2% redemption fees since 1999 to investors who have sold shares in 90 days' times or less.
Steven Witt, managing director of Firsthand Funds, said despite the decline in value of the San Jose, Calif., group's technology funds, it has no plans to remove redemption fees even though the firm lacks evidence such fees "stop surfers." Firsthand imposes 2% on shares redeemed within 180 days.
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