Like the Mafia, many mutual funds make it hard for you to leave. And the number of funds that impose penalties for short-term withdrawals is on the rise.
Fund companies are increasingly using these redemption fees to penalize investors who frequently trade in and out of funds. Earlier this year, both
tightened redemption policies on their no-transaction-fee fund networks.
Blame this trend on the small percentage of traders who treat mutual funds like the fifth race at Pimlico. Still, when you have a legitimate reason for selling a fund after a couple months of ownership, these fees are, justifiably, a source of irritation.
said that beginning Aug. 16 it will impose a 2% fee on shares of five funds that are sold within 90 days of purchase. The funds:
International Small Cap and the upcoming
. (The fee will apply only to newly issued shares of the aforementioned funds, not ones already held by shareholders.)
Oakmark "has been trying for years to stop short-term traders," says Bill Nygren, manager of the Select fund. For example, the firm has seen investors buying into one of its international funds late in the day as the U.S. markets surge as a way to play a predictable, next-day rise in the international markets. "They end up getting a pretty good profit at the expense of the long-term shareholder," he says.
Indeed, excessive short-term trading in a fund, particularly one that invests in less-liquid areas like the small-cap or international markets, can be burden shareholders.
With money flowing rapidly in and out of a fund, a manager may be forced to buy and sell securities to meet the demands of short-term traders' purchases and redemptions. Extra trading increases a fund's transaction costs, which come directly out of net asset value and therefore hurt performance.
Excessive short-term redemptions also can create unwanted capital gains.
Redemption fees aren't new and can be found in many funds, particularly no-load funds. Fidelity has redemption fees on 66 of its 108 retail equity funds. Vanguard uses them on several funds, including its now-closed
Health Care fund.
More funds are levying these fees. At the beginning of May,
added redemption fees to a handful of its portfolios, most of which invest overseas. In a May 1999 research report,
Financial Research Corp.
said the total number of funds that carry redemption fees had grown to 311 by this April from 209 in December 1997.
More fees, more fees, more fees, you cry? Redemption charges actually benefit shareholders who aren't frequent traders. The fees typically go back into the fund, rather than to the fund's corporate parent.
But you should still be on the lookout for these back-end charges.
Both Fidelity and Schwab tightened redemption policies for their no-transaction-fee fund supermarkets. So even if a fund doesn't charge a redemption fee, you could end up paying one if you bought it through one of these operations. And these giants keep the redemption fees for themselves rather than returning them to the individual funds.
So if you execute a short-term trade, you could trigger two redemption fees: the fund's underlying fee and the one charged by a fund supermarket.
At Fidelity, you will pay a transaction fee of $75 each time you sell or exchange shares of a
fund held less than 180 days. (The fee applies to no-load and no-transaction-fee funds.)
At Schwab, shares of funds bought through its
network (or other no-transaction-fee funds) must be held for 180 days. Otherwise, the fee for short-term redemptions is 0.75% of principal, with a cap of $299 for trades placed through a broker or $199 for Internet and phone trades.
Matt Sadler, senior vice president of Fidelity's FundsNetwork, ticks off three reasons for the tougher stance. The first, which I already discussed, is the cost to the fund of short-term trading.
Two, Fidelity is "doing it to help solve issues with our fund partners," Sadler says. Many "needed and wanted and requested us to toughen up our policy."
Lastly, the firm had to think about its own financial situation. Both Fidelity and Schwab are compensated on an annual basis for assets brought in through their supermarkets. They earn 25 to 35 basis points annually on that money. But for money that flows into and out of a fund in a matter of weeks, these firms might make next to nothing, especially after factoring in transaction and administrative costs.
What can be unfortunate about redemption fees, particularly the ones charged by the fund supermarkets, is that they penalize all investors, regardless of their reasons for trading. What if you want to harvest a short-term loss in a bleeding fund after a few weeks? You pay a fee. What if you decide to reallocate your portfolio after owning a small-cap fund for a month? You pay a fee.
Though fund companies argue that these fees are necessary to combat a growing number of market timers, some online brokerages say market timers are a very small problem. "We have virtually no market-timing in our funds," says Brian Murray, vice president and general manager of the mutual funds group at
The firm has a stated 90-day holding period for no-transaction-fee funds. If you sell within 90 days, you're supposed to pay a $24.95 fee. But "we have not applied it a single time," he says. Next year, E*Trade plans to replace its blanket redemption-fee policy with a more flexible program that will let fund companies choose the redemption period that E*Trade imposes.
If you're bothered by these fees, you have a couple of alternatives. To avoid a fee double-whammy, you can avoid fund networks when buying a fund that carries a redemption fee.
You can also look for a supermarket with a more favorable redemption policy.
, for example, allows five short-term redemptions in its no-transaction-fee funds (defined as positions held less than six months) in a 12-month period before it reserves the right to reinstate transaction fees.
But if you are trading funds frequently, you won't find any place to hide.
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Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.