Who says there is no such thing as a free lunch? While regulators are pushing to clean up the fund industry, some short-term shareholders are continuing to eat away at returns of other investors by driving up costs and benefiting from an inefficient system.
The Securities and Exchange Commission and other regulators are searching hard for antidotes to market timing and late trading. However, as they grapple with a possible 2% redemption fee, they are ignoring the fact that even if market timing is stomped out, shareholders invested for the long-haul are forced to subsidize the costs imposed by short-term investors, essentially creating a transfer of wealth flowing from less active investors to those more frequently moving assets, according to recently released research.
Furthermore, the study finds that mutual funds do not provide shareholders with equitable liquidity-risk insurance. Essentially, long-term shareholders pay for more liquidity than they demand, while short-term shareholders are paying for less.
The crux of the study, authored by Woodrow Johnson, a professor at the University of Oregon's Charles H. Lundquist College of Business, is that all shareholders earn the same rate of return on a fund, yet some investors generate different levels of cost.
Funds do not charge shareholders to trade fund shares. However, when a shareholder opens or closes an account, or adds or sells shares in an account, the fund manager is forced to buy or sell shares of securities in the portfolio. The fees for these transactions are not charged to the individual shareholders causing the transaction fees. Rather, they are subtracted from the fund's overall assets and reduce the overall return of everybody invested in the fund.
Even worse is the fact that fund companies have the ability to predict which shareholders are likely to abuse the system or benefit from the structure, yet do nothing to correct it.
"Investors can impose costs on a fund and are not charged their margin of cost," Johnson said. "It's kind of like an all-you-can-eat buffet. You pay one price for dinner or lunch and eat as much as you want. Some eat more than others. A high school football player is going to eat much more than a cheerleader, so she is essentially paying for his meal."
Johnson's paper focuses on transaction costs only, although there are other factors, such as tax liabilities, he said. "As shareholders trade, they're going to be making a fund manager trade. And if he sells at capital gains, for example, that's going to make the remaining shareholders have a tax liability on their personal account because of someone else's transaction."
Johnson analyzed data from one no-load mutual fund family from 1994 to 2000. The anonymous fund family, which has industry-standard fees and trading restrictions, contains about 10 mutual funds. However, while the group contains both equity and fixed income funds, the equity funds are not typical in that they generally do not hold large-cap stocks.
From the data he concluded that there are "observable shareholder characteristics" that allow the fund company to determine at the time of the account opening whether the shareholder will be a long-term or short-term investor. However, that data is not being utilized properly, he said.
"The data the fund collects during the normal course of business can be used by the fund to predict how long the investor will be in the fund. However, people who should care about what shareholders are doing don't maintain the data on shareholder trading patterns. The data I used for my study is transfer-agent level data."
Items such as investor age and the account size can be indicators of intentions and time horizon. The data shows that investors in their sixties or seventies are much more likely to close out an account than someone in their thirties or forties, Johnson pointed out, adding that those in their sixties or seventies "are likely to have a shorter horizon. On the surface we know that age is going to be a major factor."
Account size can also be a telltale indicator. The bigger the account size, the more likely it is to close. "Someone coming into an account with a couple of thousand dollars will have a much longer horizon than the person who comes in with $50,000 or $100,000," he said.
Johnson also said that the way in which funds are purchased, either from the fund directly via a transfer agent or through a broker, can be used to predict investment horizons, which in turn can help predict wealth transfers. In general, short-term investors tend to buy funds indirectly.
The cost to long-term shareholders can be significant, according to Johnson. He compared costs associated with funds sold directly, via a transfer agent, to those sold indirectly, through brokers, such as E*Trade. In order to determine the financial impact, Johnson said he set out asking this question: If a fund that is direct-sold shifts to allow indirect investors into it, how much money will be drained from long-term, buy-and-hold investors, by having other costs, such as short-term shareholders, in the fund? According to Johnson's calculations, this structure saps 51 basis points a year from long-term shareholders. "That's a big number. It's big relative to 12b-1 fees and it's big relative to management fees. In my mind, it's a real eye-popping number."
As for the proposal to impose a 2% redemption on funds held less than five days, Johnson said it is a step in the right direction, but still doesn't solve the problem of wealth transfer. "The problem is that there is going to be someone in the fund who is going to be there for 62 days alongside someone else who has been there for 20 years. So, the person who is in there for 62 days is going to be imposing, on a per-day basis, more costs on the fund than the five-year, 10-year or 20-year investor. So there will still be a wealth transfer. That proposal doesn't solve the problem."
No Easy Solution
While the report points out several inefficiencies in the system, solutions are not as easy to come by. Johnson's research is not a policy paper and offers no concrete solutions to this problem. However, he said one idea may be to separate investors into two different groups, pay them the same return, but charge the group that trades more frequently a fee that is returned to the overall assets of the fund. Another possibility is to bill the individual shareholder directly for the costs their purchases or redemption generate and put that money back into the fund.
"If shareholders are given the same return from the fund but are imposing different costs, we may want to think more carefully whether this is the correct way to structure the mutual fund industry," Johnson said.