New rules to deter abuses may ensnare all investors

Your Funds

March 07, 2004|By CHARLES JAFFE

UPON LEARNING recently that mutual funds are likely to be required to put in a redemption fee on short-term trades, the average mutual fund investor probably thought, "This means nothing to me."

That's because average investors hold their funds for a lot more than five days, which would be the minimum time you can hold a fund without paying a charge to get out the door under rules proposed by the Securities and Exchange Commission.

But every rules change brings unintended consequences, and mandatory redemption fees are no exception. In this case, the problems could snare a lot of ordinary investors.

Redemption fees are designed to discourage short-term trading in funds, the kind of rapid-fire market-timing maneuvers that have been at the heart of the industry's deepening scandals.

Unlike sales charges, redemption fees go to the fund itself, covering the fund's trading costs so that other investors do not carry the financial baggage when an investor makes a fast round-trip in a fund.

Currently, about 10 percent of funds carry a 2 percent redemption fee, the amount that the SEC is proposing to take on trades made within five days. That's nearly double the percentage of funds that had such fees prior to the start of the scandals in September. Most redemption fees apply for longer periods, often for six months or a year.

Funds designed for use by market timers are exempted from the SEC's proposal, as long as they notify investors of the cost consequences of catering to fast traders. Also exempt are trades where the fee is less than $50, meaning the fee applies to trades of more than $2,500.

Critics of the SEC rules proposal, including one of the SEC's five commissioners, have said that the five-day rule is not necessary, because funds that believe timing trades is a problem can solve them by imposing fees.

There is no reason, they argue, to impose these fees on investors in all funds.

"You would think that funds that have identified that they have an abusive-trading problem would already have the fees in place," says Peter Mauthe of Spectrum Financial Group and an executive with the Society of Asset Allocators and Fund Timers. "This covers funds that don't have the problem, and impacts investors in those funds."

Under the current system, funds can't always enforce their current fees.

That's why the regulators want to make this a mandate.

The problem occurs because people who invest through large firms get folded into an "omnibus account." In this fashion, all customers of, say, Charles Schwab, get lumped into one account. In an overly simple example, a fund is not told that "Schwab customer Joe Smith bought 100 shares and John Doe sold 50," it is only told that Schwab's customers combined to buy 50 shares.

If both individuals reverse those trades two days later, the fund only knows that a total of 50 shares was sold by Schwab investors, and it does not know that the two individuals have been in and out quickly.

You can hide a lot of trading activity that way, which is why redemption fees to date have only slightly reduced the problems associated with rapid-fire trading.

By making the redemption fee mandatory, you force those intermediaries to identify individual accounts. That stops investors from using market timing in 401(k) accounts, brokerage accounts or other places where this activity has not been ferreted out. Getting that kind of information on all accounts won't be cheap, and you can bet that fund companies will pass the cost along in the form of higher expense ratios.

What's more, if you rebalance your 401(k) account every six months and just happen to be in a fund that has a six-month redemption fee, the fund will now be identifying your trading activity and dinging your account. In fact, smooth your portfolio too often, and your fund might kick you out altogether because you make too many trades.

Rebalancing and tactical asset allocation moves are not problems the SEC wants to stamp out. Neither is following an investment newsletter that suggests occasional trades, or other investment strategies that require periodic moves.

When all is said and done, the redemption fee may not be enough to stamp out abusive trading, but the SEC currently won't make the fee more punishing. Expect traders to price the fee into their models and keep going, at which point we'll see whether fund firms - bolstered by the information on who is trading in omnibus accounts - actually step up and enforce their rules and bar the day-traders from their funds.

But in trying to eliminate the cost that rapid-fire trades exact from funds, regulators need to keep in mind that the cost of implementing all the new rules - there are others proposed and more on the way - may be even worse.

Baltimore Sun Articles
|
|
|
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.