Mutual Fund Redemption Fees Can Benefit Long-Term Investors

Journal of Financial Planning; May 2014


David Nanigian, Ph.D., is an associate professor of investments at The American College. He is internationally known for his research on mutual funds and regularly teaches a course on mutual funds in The American College’s Master of Science in Financial Services program. EMAIL author.

Brokerage costs and other transactions costs, such as bid-ask spreads and price impact, have a meaningful impact on the returns on the part of a client’s portfolio that is directly invested in individual securities. However, middle market clients often make indirect investments, rather than direct investments, in individual securities through mutual funds. Mutual funds often buy and sell securities for their portfolios to meet the purchase and redemption requests of their shareholders.

The ultimate impact of these liquidity-motivated transactions within a mutual fund’s portfolio on returns is difficult to gauge. This is because the prices at which securities in the fund’s portfolio are transacted at cannot be directly observed by clients. However, the impact of these trading costs is economically meaningful.

For example, 2013 research by Roger Edelen, Richard Evans, and Gregory Kadlec (“Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance” published in Financial Analysts Journal) shows that, on average, a mutual fund’s annualized trading costs comprise 1.44 percent of its total net assets. In contrast, mutual fund’s operating expenses and management fees comprise, on average, only 1.19 percent of total net assets. Moreover, 2011 research by these same authors (“Information and Implementation: Assessing the Net Impact of Trading on Mutual Funds” posted on SSRN) shows that trading costs can forecast fund returns better than operating expenses.

These studies motivate the need for financial planners to consider how focused a mutual fund is on managing its trading costs when selecting a fund for a client. The purpose of this column is to summarize the practical implications of recent research on investing in funds with short-term redemption fees as a means of controlling exposure to these costs and ultimately improving returns.

Funds with Redemption Fees Can Outperform Counterparts

One of the first papers to focus specifically on redemption fees was a joint project I did with Michael Finke at Texas Tech University, and William Waller at the University of North Carolina at Chapel Hill (see “Redemption Fees: Reward for Punishment,” posted August 10, 2012 on SSRN). Unlike most other fees incurred by fund investors, redemption fee proceeds do not go into a fund company’s pockets. Instead, they become part of the general assets of a fund’s portfolio, which is owned by its shareholders.

Redemption fees negatively impact the returns on the portfolio of a client who redeems his shares during the time period in which he would be subject to the fee, which is typically less than one quarter. However, through a combination of discouraging short-term traders from purchasing shares in a fund, encouraging current shareholders to be long-term investors, and collecting redemption fees from shareholders who do engage in short-term trading, mutual funds with redemption fees outperform their counterparts.

We regressed the risk-adjusted performance of U.S. equity funds on a variable indicating whether or not a fund has a redemption fee and a set of control variables. We found that funds with the fee outperformed those without it by 1.0 to 1.4 percentage points a year, depending on the metric of performance used as the dependent variable in the regression model. Moreover, the impact of having a redemption fee on performance was statistically significant at the 1 percent level.

Fees Are a Deterrent to Short-Term Trading

The 2007 paper “Daily Mutual Fund Flows and Redemption Policies,” by Jason T. Greene, Charles W. Hodges, and David A. Rakowski, published in the Journal of Banking and Finance, found that domestic equity funds initiating a redemption fee experienced a 78 percent decrease in the magnitude of daily fund flows, and that 72 percent of these funds experienced a decrease in the volatility of daily fund flows, suggesting that such fees are a strong deterrent to short-term trading activity.

Moreover, my 2012 work with Finke and Waller found that domestic equity funds experienced a 0.77 to 1.02 percentage point decrease in the proportion of their portfolios held in cash following the initiation of a redemption fee. We presume that this occurs because fund managers are aware that money flow typically becomes less volatile after a redemption fee is imposed. Therefore, they become less concerned about the possibility of a surge in redemption requests, and the resultant selling of portfolio holdings at “fire sale” prices, after the fee is initiated. Because this concern is alleviated, they hold less of their portfolios in (low-yielding) cash, which enables them to generate higher rates of return for their shareholders.

Our work focused on domestic equity funds, yet it is in international equity funds where short-term trading by fund shareholders is most likely to occur. This is because returns have become highly correlated around the world, and stock markets around the world operate at different times, which means that many international funds trade at stale net asset values. Therefore, one can predict how one country’s stock market will perform tomorrow based on the performance of another country’s stock market today. For example, if the United States’ stock market performed well today, we can reasonably expect that Japan’s stock market will also perform well when its market opens for trading. Therefore, one can earn arbitrage profits by buying a Japan equity fund today at a stale net asset value and selling it tomorrow.

Research by Rahul Bhargava and David A. Dubofsky (“A Note on Fair Value Pricing of Mutual Funds” published in the Journal of Banking and Finance) and William Goetzmann, Zoran Ivkovic, and K. Geert Rouwenhorst (“Day Trading International Mutual Funds: Evidence and Policy Solutions” published in the Journal of Financial and Quantitative Analysis) show that such trading strategies are quite profitable.

Redemption Fees in International Equity Funds

In their 2012 Journal of Investment Management paper, “Redemption Fees and the Risk-Adjusted Performance of International Equity Mutual Funds,” Iuliana Ismailescu and Matthew Morey examined changes in the Sharpe ratios of international equity mutual funds following the initiation of a redemption fee. The authors found that 128 of the 157 funds in their sample experienced increases in their Sharpe ratios following the initiation of a redemption fee. They also found that the mean Sharpe ratio increased from 0.0937 over the three-year period preceding the initiation of the fee, to 0.3445 over the three-year period following the initiation of the fee.

Furthermore, Ismailescu and Morey found that funds experienced a 0.66 percentage point decrease in the proportion of their portfolios held in cash following the initiation of the fee. This confirms the findings of my 2012 work with Finke and Waller, suggesting that much of the improvement in a mutual fund’s performance following the initiation of the fee can be explained by declines in cash holdings, which likely arise from eased concerns about the possibility of a redemption shock.

In summary, the short-term traders in a mutual fund drag down the returns to the long-term investors because the fund must engage in costly liquidations of securities in order to fulfill redemption requests. Alternatively, the fund may hold a large reserve of low-yielding cash to avoid selling securities at “fire sale” prices.

Many mutual funds impose a short-term redemption fee to reduce the unfair transfer of wealth from the long-term investors to the short-term traders in a fund. Research has shown that the fee is quite effective in this regard, as funds experience lower money flow volatility and cash holdings following the imposition of the fee. Perhaps most importantly, research has also shown that funds with redemption fees outperform those without redemption fees by more than 1 percentage point per year on a risk-adjusted basis, which can have a rather meaningful impact on a household’s wealth accumulation over time.

Investment Planning