Speech by SEC Staff:
Mandatory Redemption Fees Opening Statement
Paul F. Roye
Director, Division of Investment Management
U.S. Securities and Exchange Commission
February 25, 2004
The Division of Investment Management is recommending today that you propose for public comment new rule 22c-2 under the Investment Company Act. The rule would require that mutual funds charge a redemption fee of 2 percent on the proceeds of mutual fund shares that an investor redeems within 5 days after purchasing the shares. The rule is designed to require that funds recoup the costs that frequent traders in fund shares impose on the fund. As you mentioned, Mr. Chairman, this rule also is part of the other initiatives the Commission has undertaken in the past several months to remedy a variety of abuses suffered by funds in the form of market timing, selective disclosure of portfolio securities, and late trading in fund shares.
Short-term traders in mutual fund shares come in different shapes and sizes. Sometimes shareholders buy fund shares, and then change their mind soon afterwards. They redeem their purchase, or exchange their shares for a different fund. These frequent purchases and redemptions impose costs on the fund, such as administrative costs for the fund and its transfer agents, and brokerage costs that result from investing and then liquidating positions.
Other frequent traders include market timers – small and large – who try to time their purchases to take advantage of market action they believe will occur in the future. These short-term shareholders often trade fund shares to shift their investments into the hottest sectors of the economy. These traders can also trade through accounts that offer them the ability to exchange shares without fees or tax consequences, such as retirement plans.
Another type of market timer attempts more directly to take advantage of the fund’s long-term shareholders by exploiting how funds calculate their net asset value. These market timers buy and sell shares if the fund’s daily calculation of net asset value significantly lags behind the current values of its portfolio securities. These market timers typically trade in international funds and other funds that invest in illiquid securities.
The costs of all of these frequent traders are paid by the fund and the shareholders who remain in the fund. Over time the long-term shareholders will, in effect, pay the costs of the short-term shareholders’ transactions. Many of the short-term shareholders may not appreciate the costs that their frequent trading imposes on the fund.
Some funds today impose redemption fees on short-term transactions in fund shares. But as you pointed out, Mr. Chairman, these funds typically do not impose these fees on shares held through financial intermediaries, because they cannot obtain information on the individuals who own shares through those institutional accounts. Therefore, even the 10 percent of funds that do impose redemption fees typically cannot impose the fees on investors who hold shares through broker-dealers, 401(k) plans, and similar arrangements.
The rule we are recommending that you propose would require funds to impose a 2 percent fee on shares held for 5 days or less. This rule is not designed to be the “ultimate solution” to the problems posed by market timers engaging in time zone arbitrage. The best solution to that problem is the requirement that mutual funds “fair value” any securities whose daily market quotations are stale or unreliable. Unfortunately, however, fair value pricing is not an exact science and involves many subjective factors. And fair value pricing does not address the costs that a fund pays because of those frequent traders who simply change their mind or react precipitously to current events. Therefore we see the redemption fee proposal as a “user fee” that the fund should impose on frequent mutual fund traders, so that it can recoup the costs of the frequent redemptions. Such a redemption fee, together with fair value pricing, can serve to reduce – if not eliminate – the profits that market timers seek to extract from the fund.
We chose a 2 percent fee, rather than a higher or lower one, because we believe that it strikes an appropriate balance between protecting the fundamental concept of “redeemability” as required by the Investment Company Act and recovering the costs of excessive trading. We chose a 5-day holding period because we believe it would target the most egregious patterns of excessive trading, the very rapid in and out trading. We considered recommending a longer holding period, as part of the rule, but decided that the exceptions that would be needed for such an approach could make the rule overly complex and difficult to enforce.
Small Investors. Of course, any across-the-board rule poses certain risks when applied broadly to all investors. We tried to be sensitive to the risk that small investors might be unfairly disadvantaged if they unwittingly redeem soon after they purchase their shares. Therefore the rule calculates the shares on which the redemption fee will be calculated in the following way – the shares held the longest will be considered to be the ones that are redeemed first. This is a familiar accounting method called first-in, first-out, or FIFO. It would ensure that redemption fees are assessed on the shares held the longest period of time, and will minimize the likelihood that redemptions of part of a shareholder’s holdings will be assessed a redemption fee.
The rule also would include a de minimis exception under which the fund would not be required to impose a redemption fee.
Finally, the rule would contain a provision regarding waiver of the fee in the event an investor has a personal or financial emergency that requires redemption of shares within the five-day period.
Exceptions. The rule also does not apply to certain types of mutual funds: It wouldn’t apply to money market funds or exchange-traded funds. It also wouldn’t apply to that small group of funds that are actually geared to attract market-timers if they clearly disclose in their prospectus that they permit market timing, and that this frequent trading can impose costs on the fund. Even the long-term investors in these funds will be on notice that short-term trading is the norm in these funds.
Omnibus Accounts. As you mentioned, Mr. Chairman, the proposed rule would require funds and intermediaries, such as broker-dealers and retirement savings plans, to work together so that either the intermediary assesses the redemption fee and forwards the proceeds to the fund, or provides enough information for the fund to assess the redemption fee on all shareholders. At your request, Mr. Chairman, the NASD convened a panel of experts from numerous groups, including broker-dealers, mutual fund sponsors, and third-party administrators, to address short-term trading through accounts held with intermediaries. The Task Force submitted a public report that was very helpful to us in making these recommendations, and we greatly appreciate their efforts under the leadership of the NASD staff.
The rule would provide different methods by which the fund could work with these intermediaries to assess the redemption fee. In addition, the rule would require intermediaries to deliver to the fund enough shareholder information so that the fund can oversee the intermediaries’ efforts to collect the fee. Fund managers can use this information also to better enforce their market timing policies, including barring frequent traders from the fund.
Fair Market Value. As I mentioned earlier, a redemption fee, together with fair value pricing, can serve to reduce – if not eliminate – the profits that market timers seek to extract from the fund. The Investment Company Act already requires funds to fair value their securities when reliable quotes are unavailable. The Commission recently emphasized the need to put effective fair value procedures in place when you adopted the compliance procedure rules in December. There is no uniform method or single standard for fair value pricing because it necessarily requires some measure of judgment and flexibility.
The Commission’s examinations staff is currently gathering information about funds’ fair value pricing practices. The Division of Investment Management also is examining the pricing methods used by funds, and the quality of those methods, to evaluate whether to recommend additional measures to improve funds’ fair value pricing. With these initiatives in mind, the draft release would ask for preliminary comments on fair value pricing as it relates to abusive market timing, as well as other possible tools to combat abusive market timing.