In an effort to limit market timing activity, firms are increasingly attaching redemption fees to funds. As of the end of March, 585 funds charged redemption fees, up 82 percent from the end of 1999, according to a study by Financial Research Corporation of Boston.
"Increasingly ... individuals are eschewing the buy-and-hold mantra, believing that active sector rotation and dynamic asset allocation strategies can result in superior returns," according to the FRC study. "This disruptive movement of assets in and out of funds forces a portfolio manager to either maintain excessive cash reserves or sell securities unwillingly in order to meet redemption requests."
As a result, firms are imposing redemption fees for a certain length of time to ensure that investors hold their shares and to ward off market timers. Suggestions that firms add redemption fees not only for that reason, but also to retain assets, especially in tougher times were dismissed by some analysts. That is unlikely due to the short period that the fees last, according to Kunal Kapoor, a senior fund analyst with Morningstar of Chicago.
"I don't really think firms do it to retain assets because most of the schedules are not much more than six months or so and that's really not a long time," said Kapoor. "Most people who are going to hold a fund for that short a period of time are really short-term traders or market timers."
Still, the period in which fees are charged has also lengthened, moving from an average of 7.5 months at the end of 1999 to 9.4 months at the end of March, according to FRC. The level of the fees though has remained constant. The average was 111 basis points at the end of 1999 and 113 at the end of March of this year, according to FRC.
The Securities and Exchange Commission imposes a two percent limit on redemption fees. That was challenged briefly last year when the SEC realized that Fidelity Investments of Boston charged a three percent redemption fee on its Small Cap Stock fund that it had introduced in 1998, according to Morningstar. Last May, Fidelity reduced the fee to avoid a legal dispute with the SEC (MFMN 5/8/00). The SEC is sympathetic to firms that want to limit market timers, but will be rigid about the two percent cap except in extraordinary circumstances, said Paul Roye, director of the SEC's division of investment management, last month at the Investment Company Institute's general meeting in Washington, D.C.
Fidelity and Vanguard of Malvern, Pa., have traditionally charged redemption fees for a number of their funds. Recently, other firms have added them as well, according to FRC. In March, Putnam Investments of Boston added redemption fees for the first time in the company's history to its Asia Pacific Growth fund and Emerging Markets fund, according to FRC. Effective Sept. 1, OppenheimerFunds of New York will add redemption fees for the first time to seven funds.
Sector funds are more likely to carry redemption fees because they are less liquid, according to FRC. Technology funds led all categories with 47 percent imposing fees while 45 percent of communications funds did. Region-specific funds are also more likely to impose fees because short-term investors tend to target them to gain from the time difference between markets, according to FRC. Forty-three percent of Pacific/Asia funds, not including Japan, and 32 percent of Japanese stock funds charge redemption fees, the study found.
Some fund firms take advantage of the fact that some investors want to trade shares actively, according to FRC. The Rydex, ProFunds and Potomac fund groups are examples of families that have actively sought out market timing investment advisors, according to the study. Schreiner Capital Management of Exton, Pa. will soon launch a wrap platform designed for those investment advisors, according to FRC. Schreiner will allocate invested assets in funds that accept market timing accounts and will charge a 2.5 percent fee for the service, one percent of which pays advisors, according to FRC.
Analysts disagree as to whether attaching redemption fees actually does dissuade market timers. The two percent cap imposed by the SEC may be too low to really be effective, according to some analysts.
"[Morningstar has] done some studies that show that while the fees seem like a good idea on their face, they really haven't done much to curtail market timing," said Kapoor. "One of the reasons is that they are not very high redemption fees. Some investors are willing to pay that anyway."
Still, the growth in the number of funds that use them is likely to continue, according to FRC.
"There is no reason to believe that the proliferation of redemption fee implementations will cease, especially with the continued launching of tax-managed portfolios, sector funds, region-specific international offerings as well as the increased numbers of investors with short-term investing horizons," according to the study.
