Market timers raise costs for everyone

Mutual Funds

August 08, 1999|By Kathy Bergen | Kathy Bergen,CHICAGO TRIBUNE

The intertwined ascents of online trading and mutual fund supermarkets have made it possible to zip in and out of many mutual funds in an instant, and with no upfront transaction costs.

This is making many mutual fund companies very nervous.

In particular, they are worried about the potential damage that could be inflicted on their funds -- and their long-term investors -- by increasing numbers of market timers who hop in and out of holdings swiftly, trying to capture gains and avoid losses on quick price movements.

The funds' defense, increasingly, has been to inflict financial pain on frequent traders, in the form of fees assessed when shares are redeemed after a short period. More than 300 funds have redemption fees now, up 50 percent since December 1997, according to Financial Research Corp., based in Boston. Typically, the fee charged by fund firms is 1 percent of assets held less than a specified period, say, three months, six months or a year.

While the rise in the number of funds with redemption-fee structures is significant, 300 funds still amount to only about 3 percent of the mutual fund universe. Of broader significance, perhaps, is a recent toughening of redemption-fee rules by the nation's mutual fund supermarkets, which generally keep the fees they collect.

This year, for example, Boston-based fund giant Fidelity Investments tightened its policy regarding short-term trading of shares in the 900 funds sold with no transaction fees or sales loads through its FundsNetwork supermarket.

Redemption fees are assessed if shares are held less than 180 days. The fee for online transactions is $75; the fees for transactions conducted through a company representative range from $100 to $250, depending on asset level.

Previously, fees were not assessed until an investor had made five or more short-term redemptions within a year.

Fund supermarket powerhouse Charles Schwab & Co. also has tightened its redemption policy.

Late last year, it added three months to the minimum holding period on the more than 1,000 funds available on a no-transaction-fee, no-load basis through its OneSource supermarket.

Now, anyone who cashes out in less than six months will be charged 0.75 percent of assets, up to a maximum of $199 if the transaction was electronic or $299 if not.

Fund supermarkets "are trying to tell fund companies, `We are on your side of the table; we want to make sure the bad apples don't spoil the pie,' " says Geoff Bobroff, a consultant to the investment management industry.

Aggressive trading can cause problems for individual fund companies and their shareholders in a number of ways, observers say.

For starters, it can force fund managers to keep a lot of cash on hand to honor potential redemptions. The cash hoards can dampen a fund's performance in a rising market.

Second, when cash reserves are insufficient to cover redemptions, a fund manager may have to sell stock at a less-than-optimal time in order to meet redemptions -- a move that can also erode performance.

This problem is particularly acute at smaller funds with specialized, less liquid holdings.

Fund companies sometimes add redemption fees or toughen existing policies after spotting a red flag such as money pouring into, or out of, a fund.

Some financial planners who counsel their clients to invest for the long haul are happy to see such fees proliferate. "I have to tell you, I like 'em," says Gary Bowyer, a fee-only financial adviser based in Chicago. "People jumping in and out of funds on a short-term basis hurts the long-term shareholder."

Still, the fees have their critics, among them Doug Fabian, a fund-industry critic who publishes a quarterly "lemon list" of worst-performing mutual funds.

He sees the increasing use of the fees as a strategy by fund companies to hang on to assets in a climate where redemptions are on the rise.

While he doesn't quibble with use of the fees on smaller funds with illiquid holdings, he objects to them on larger, more liquid funds, such as index funds. He really objects to fees placed on funds whose managers have poor track records.

The fund companies' contention that they institute the fees to protect longer-term investors is "a whole bunch of baloney," says Fabian, president of Fabian Investment Resources, a Huntington Beach, Calif., publishing firm.

"What protects shareholders is great performance by managers."

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