Gaming the Redemption Fee Free-for-All

Will the proposals for changing redemption fees make a difference? Here's the scoop.
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Vanguard founder John Bogle, the real-life Mr. Smith of the mutual fund industry, went to Washington this month to offer a Senate Subcommittee on Financial Management some remedies for the market-timing mess. In his testimony, he urged the senators to push the

Securities and Exchange Commission

to "impose a redemption fee of 2% for shares held for less than, say, 30 days."

This proposal seems sensible. By adding a mandatory fee, Bogle wants funds to announce that only long-term holders need apply. And any time Bogle talks about adding fees as opposed to stripping them away, this should sound alarms. (Some funds have such fees in place already, but others don't.)

So why did Bogle suggest 30 days for those redemption fee fines? Why didn't he say five days like the Investment Company Institute, the industry trade group, is proposing? And why 2%? Why not 1.99%? Are these arbitrary cutoff dates like voting or driving ages?

And what the heck is a redemption fee anyway?

That's probably a pretty good place to start.

Some mutual funds, not all of them, charge redemption fees to shareholders who elect to redeem, or sell, their shares. Sounds intuitive enough. Whether it be a stock, bond or fund, there's going to be some kind of charge on the way in, or, as in the case of redemption fees, on the way out.

Nevertheless, there is a slight difference when it comes to this particular type of exit fee. Although a redemption fee is deducted from sales proceeds just like a back-end sales load, it is not considered to be a sales load. The difference is that unlike a sales load, which is generally used to pay the broker who sold you the fund in the first place, a redemption fee typically goes back to the fund. The fees paid to the fund are then used to offset fund costs associated with the shareholder's redemption.

The SEC generally limits redemption fees to 2%, and they usually have an expiration date. Long-term shareholders, therefore, not only benefit from the money sent back to the fund upon redemption, but the unusually high fees serve as a deterrent to short-term investors -- now known as market-timers -- looking to make a quick score.

In poker parlance, it's the same as kicking back some money to the pot so your friends can keep playing all night, while at the same time preventing new players from running away with your money after two or three lucky hands.

So now that we know what a redemption fee is in both financial and poker terms, why does Bogle want me to hold 'em or fold 'em after 30 days, while the ICI says five days is plenty? What's the difference? And does it matter?

It does.

"It was determined that a five-day period would be able to capture virtually all abusive short-term trades," said ICI spokesman Chris Wloszczyna, who noted that the five-day recommendation came down from the group's executive committee that includes ICI Chairman Paul Haaga and Vanguard Chairman John Brennan.

Wloszczyna's chief concern was that the 30-day period may inadvertently harm the financially conscientious long-term shareholders it's meant to protect. "If you are in a 401(k) program and you are putting money into a fund every two weeks, occasionally you have to adjust your portfolio," said Wloszczyna. "If it's a 30-day period, you will be hit with a redemption fee just for shifting money between funds."

Morningstar spokesman Kunal Kapoor, on the other hand, favors a "longer is better policy" when it comes to redemption fees. However, Kapoor is like-minded with the ICI when it comes to the effectiveness of the fees themselves.

"Redemption fees are the most effective way to combat market-timing. People point to the need for fair-value pricing as a solution, but a lot of fund companies have not figured out how to do that," said Kapoor. (Fair-value pricing is a method of adjusting the value of a fund's shares by incorporating after-market news into a fund's NAV price. Since the majority of market-timers preyed on international funds, a fair-value pricing solution would mark a foreign stock to the U.S. market so any after-the-bell news is discounted, thus eliminating arbitrage and market-timing possibilities.)

Whether or not the solution is a five-day minimum or a 30-day minimum is an important point, but not the focal point for either Wloszczyna or Kapoor. Most important to them is a mandatory, uniform solution to the problem, so they can patch the cracks where market-timers have been able to slide through.

"Make it mandatory so everybody knows the rules," said Wloszczyna. "Making it uniform simplifies it."

Kapoor notes, "Fund companies have become notorious for making exceptions for certain groups, and if a redemption fee is to become effective it needs to be enforced in the spirit it was created."

There you have the long and short of it when it comes to long and short redemption fees. But what about the case against redemption fees entirely?

Max Rottersman, founder of

FundExpenses.com, makes that case. Rottersman says the fees "get in the way of a mutual fund" and that the call for mandatory redemption fees "is overreacting to the problem by trying to put a simple band-aid on it. And that's not the answer."

Rottersman says that offering hard numbers as a solution to the problem will just spur people to find ways to get around it. In fact, Rottersman says it was "insider information" that is at the heart of the market-timing scandal. "Once you take insider information out of the equation, you are going to see most of the problem go away," said Rottersman.

Rottersman and

FundAlarm.com publisher Roy Weitz are also concerned that small investors who might have a legitimate excuse to sell their funds on a moment's notice -- let alone 30 days -- will be punished by mandatory fees.

Weitz likes the idea of redemption fees but would include an "escape valve for those who make a mistake or have a legitimate emergency like a fire or losing a business line of credit."

Weitz says that individuals who need to redeem shares in the face of an emergency can appeal to their fund in the form of a letter or phone call. He doubts that market-timers looking to abuse the system will go to the effort to keep pleading for exceptions. And if they do, they will just be spotlighting themselves.

Concludes Weitz, "It's not going to be a perfect system, but if you can get rid of 98% of the problem, it's a very good start."