SEC OKs redemption fees

NEW YORK – It could be the only fee you’re happy to see your mutual fund charge.

Redemption fees are widely considered a good thing for long-term investors because they help mutual funds recoup trading costs incurred by those who hold shares for only a short time. A recent decision by the Securities and Exchange Commission confirms regulators’ commitment to the use of redemption fees to combat market-timing in mutual funds, but some still question the legitimacy of these exit charges.

It’s not that there’s anything wrong with short-term trading, or even market timing. But mutual funds have evolved as a vehicle for long-term investors, which makes them an inappropriate vehicle for the short term. At the heart of the problem, costs imposed by frequent traders are borne disproportionately by long-term shareholders, said Mercer Bullard, chief executive of Fund Democracy, a fund shareholder advocacy group, and a securities law professor at the University of Mississippi.

“As a general matter, investors should be pleased with the existence of redemption fees, because it reduces the fund’s overall operating costs,” said Bullard, a former assistant chief counsel at the SEC. “You do not want market timers in your fund because they drive up your costs. In a fund designed for long-term investors, market timers are your enemy, not your friend.”

In fact, if a fund charges a hefty redemption fee, Bullard said, it should serve as a clear warning that it’s not appropriate for anyone with a short-term horizon.

Redemption fees typically are charged when an investor sells a position held for less than a period of time specified in the prospectus, usually ranging from a few days to six months, or in rare cases, several years.

Last month, the SEC voted to permit, but not require, mutual funds to impose redemption fees of no more than 2 percent of the value of shares redeemed if they find it necessary to recoup the costs associated with short-term trading. Under the rule, the fund itself would retain the proceeds – meaning the fees go back into the pot held by other shareholders rather than to the fund’s manager. The rule does not apply to money market funds and exchange traded funds.

Many traditional mutual funds already have adopted redemption fees to prevent market-timing; Fidelity Investments has been using them since 1989.

“We think they’re the strongest tool funds have to work with market timing problems,” said David Jones, senior vice president of Fidelity Management Research, the mutual fund company’s investment management arm. “Most investors will never pay it, but it assures that someone who is thinking of investing in a fund with a short-term time horizon will think twice about it … or they’ll pay their own way.”

Not everyone agrees redemption fees are such a great idea, of course. Among their detractors is the National Association of Active Investment Managers, a non-profit group of registered investment advisers who use market timing strategies to manage assets invested in mutual funds. Peter Mauthe, a member of NAAIM’s board of directors and the chief operating officer of Rhoads Lucca Capital Management, said the people he’s seen most often hurt by redemption fees are small investors – the very group they’re supposed to protect.

“The only way an investor will never have to sell a fund for the next six months is by asking them to be clairvoyant,” Mauthe said.