When regulators began attacking rapid trading of mutual funds, many funds rushed to slap on redemption fees. The SEC encouraged the practice, proposing last year that anyone who sells a fund within five days of purchasing it should pay a 2 percent redemption fee. But with industry critics opposing the proposal, fee advocates are having second thoughts.
The SEC backed down recently, ruling that individual fund boards could decide whether or not to impose fees. Sensing the new mood, several fund companies — including MFS, Lord Abbett and Gabelli — have dropped some redemption fees. “With the focus on market timing, there was a knee jerk reaction to impose fees,” says Gavin Little-Gill, an analyst with TowerGroup, a consultant in Needham, Mass. “Now people are stopping and trying to figure out the most effective way to handle problems.”
The recent debate over redemption fees is hardly the industry's first encounter with the issue. A flurry of redemption fees began appearing in the mid-1990s when funds faced big moves of hot money. If 10 percent of assets went out the door in a single week, as happened to some funds, managers had to raise funds quickly by selling shares into a falling market. That magnified losses and hurt loyal shareholders. By charging redemption fees, managers hoped to slow stampedes.
When the fund scandals broke in 2003, proponents of redemption fees focused their attention on so-called market timing, which involves a rush of rapid purchases and sales. Since regulators shined a spotlight on market timing, the practice has largely vanished, analysts say. But did redemption fees play a role in stopping the speculation? Probably not, says Don Cassidy, an analyst for Lipper. His analysis of trading volume in funds before and after the regulatory scrutiny shows that funds with redemption fees have about the same trading volumes as funds without the fees.
Concerned that redemption fees may not provide a solution, fund companies have been trying other approaches.
In April, Lord Abbett eliminated 2 percent redemption fees and installed a new policy on redemptions. Now anyone who sells $5,000 worth of shares in a fund cannot make any new investments in that portfolio for the next 30 days. The aim is to stop questionable activity by careful monitoring and making sure that stocks are always priced fairly. “It takes a range of tools to protect shareholders from rapid trading,” says Jason Farago, a spokesman for Lord Abbett.
Forward Funds started ReFlow Management Co. to handle redemptions. When someone sells shares, ReFlow steps in and buys them. That way portfolio managers need not worry about facing floods of redemptions. By monitoring suspicious trading and using technique's like ReFlow's, funds may go a long way to protecting shareholders from the costs of rapid trading.