Growing number of mutual funds charge redemption fees

To ward off market timers and discourage nervous investors, a growing number of mutual funds are charging shareholders when they bail – even if it’s months, or years, after they buy the fund.

The trend is also a sign that some fund companies are pulling out all the stops to hold on to assets in a market in which many investors have stopped putting money into funds, and even more are yanking it out.

“The companies that have wanted to weed out market timers have already done that,” says Scott Daly, a New York-based adviser with New Century Financial Group LLC in Princeton, N.J., which oversees more than $200 million.

“What you have now is a tremendous amount of individuals trading frequently, and that is throwing fund companies out of whack.”

No ebb to this tide

The number of funds that imposed so-called exit fees surged 82% to 585 over the 15-month period ended March 31, according to Financial Research Corp., a consulting company in Boston.

Meanwhile, the average length of time the fees remained in effect climbed to 9.4 months, from 7.5 months during the same period, FRC says.

At the end of the first quarter, 150 fund companies charged redemption fees on at least some of their funds, up from 77 at the end of 1999, according to FRC.

“There’s no reason to believe this trend is going to ebb at all,” says Whitney Dow, an analyst at FRC. “In fact, it will probably continue.”

Fidelity Investments, the Vanguard Group and many other firms also use exit fees, particularly on sector, small-cap and international funds to which traders tend to gravitate or where liquidity often runs thin.

In most instances, the fees paid go back into the fund, and shares that were purchased before the fees went into effect are not subject to the charges.

The proliferation of redemption fees, which typically are in place for 30 days to one year, is a clear signal that fund companies are stepping up their efforts to ferret market timers from their funds.

Market timers, who are professional investors, and financial advisers who frequently jump in and out of the stock market wreak havoc for funds by causing huge swings in cash flow.

By forcing managers to incur capital gains when they sell stocks to meet redemptions, market timers also hurt long-term investors, fund companies say.

Predictably, market timers see things differently.

“I don’t believe redemption fees serve anyone’s best interest, except for the companies’,” says Paul Schatz, president of the Society of Asset Allocators and Fund Timers Inc., a Denver-based trade association for active money managers.

“The mutual funds obviously want you to put your money in and leave it for life so they can keep on collecting their fees,” he says.

Advisers are keeping a close eye on redemption fees.

While most understand why fund companies are implementing them, few advisers are willing to steer clients in the direction of funds with redemption policies that are too restrictive.

“I don’t think I could recommend a fund with a five-year restriction in good conscience,” says Paul Seibert Jr., an adviser at Asset Management Associates in Sandwich, Mass. Mr. Seibert oversees about $6 million.

“I wouldn’t have a problem with a year, but if it went much beyond that, I would.”

Indeed, investors are growing increasingly less loyal. The average holding period for mutual funds stood at 2.9 years in 2000, down from 5.5 years in 1996, according to a report released early this year by FRC.

“If you take that type of information and contrast it with lengthening fee schedules, those lengthening fee schedules could be perceived as an asset-retention strategy by fund companies,” says FRC’s Mr. Dow.

Companies such as Vanguard require investors to hold shares for five years to avoid being penalized.

On five funds, the Malvern, Pa., company charges investors 2% if investors redeem within the first year and 1% for bailing out between years two and five.

“I wouldn’t tell somebody to put money in the stock market unless they were planning to keep it there for five or 10 years,” says Jeffrey Molitor, a principal at Vanguard. “So, in that light, is five years a bad number? No, it really isn’t.”

Then there’s the $3.2 billion Federated Kaufmann Fund, which is one of 26 funds that maintains a perpetual exit fee.

The fund, purchased by Pittsburgh’s Federated Investors last month, charges those who had money invested before it was acquired 0.2% of assets to cash out, regardless of how long their money had been there.

For new shareholders, Federated has created three new share classes, none of which come with such a fee.

The Securities and Exchange Commission traditionally has taken a hard line against redemption fees.

Last April, Fidelity Investments lowered the redemption fee on its $1.1 billion Small Cap Stock Fund to 2%, from 3%, after the SEC made it clear it would not tolerate fees higher than 2%. At the close of the first quarter, the average redemption fee totaled 1.13%, up slightly from 1.11% at the end of 1999.

“We don’t want to see redemption fees used as a punishment,” says Cynthia Fornelli, deputy director of the SEC’s division of investment management.”One of the hallmarks of a mutual fund is that investors can get in and out whenever they want to,” she says.

Redemption fees are not the only tool at a fund company’s disposal for weeding out frequent traders. Many also put limits on the number of exchanges investors are allowed to make within the fund group.

For example, Fidelity reserves the right to halt trading on investors who move in and out of a fund more than four times a calendar year. Aim Management Group Inc. in Houston has eliminated $1.4 billion in market-timing assets since limiting shareholders in all its some 50 funds to just 10 exchanges a year.

Aim rejected the idea of imposing redemption fees, in part because their effectiveness is questionable, says Ira Cohen, vice president of operations. “I can’t tell you how many proposals I get from timers that say, `Feel free to charge me per exchange.”‘ he says.

Regardless, the number of funds charging exit fees is bound to increase. For the first time in its 64-year history, Putnam Investments in March began imposing a 1% fee on shares redeemed or exchanged within 90 days on two of its funds, the $256 million Putnam Asia Pacific Growth Fund and the $101 million Putnam Emerging Markets Fund.

The Boston company, a unit of insurer Marsh & McLennan Cos. Inc. in New York, is also considering plans to charge exit fees on its 10 other global and international funds.