April 14, 2004
I am author of How to Select and Use Mutual Funds published by CCH, Inc., and I frequently speak and write on mutual fund investing issues. I will be making comments about a number of SEC proposals to regulate the mutual fund industry. This particular comment is in regards to the proposed SEC rule to impose a two percent redemption fee on sales of mutual fund shares five days following their purchase.
In general, I am opposed to the concept of redemption fees because they are excessive and the redemption period is arbitrary. I see some merit in the SECs attempt to limit short-term trading, but a two percent, mandatory redemption fee is excessive and punitive. When I can buy 5,000 shares of IBM through Ameritrade for a cost of 10.99, why can the mutual fund justify two percent to liquidate my mutual fund shares? If the price of IBM is 90, the principal amount of the transaction through Ameritrade is 450,000, 90 x 5,000. Why should it cost me 9,000, 450,000 x 2, to sell my mutual fund shares worth 450,000?
The problem, of course, is that mutual funds dont disclose the costs of trading, because they arent required to make such a disclosure, and because mutual funds have soft-dollar arrangements, which should be prohibited, with brokers at undisclosed terms.
The other problem deals with the period of time. Mutual funds, of course, prefer to retain investors capital for as long a period of time as possible. That is why Vanguard levies a redemption fee of one percent when shares in its Vanguard Health Care Fund, ticker VGHCX, are sold before the expiration of FIVE YEARS. Thats right...five years. That makes your five-day period seem ridiculously short. Of course, Vanguards five-year period is ridiculously long.
Short-term trading imposes other costs on a fund, but those costs have little to do with commissions or other transaction fees. Most of the costs incurred by the fund are labor-intensive costs to rebalance a funds holdings after a particularly large redemption occurs. Small redemptions of 2500, as you note in the proposed rule change, do not create such a burden, but I suggest that redemptions of up to 100,000, or more, should not overly burden the portfolio manager to rebalance a portfolio.
Investors also frequently make silly mistakes that need correction and charging them two percent adds insult to injury. For example, there are many funds with similar names, and investors have not learned that ticker symbols are the best identification method. When they discover their mistake, they should be allowed to correct the error without being penalized for doing so. They should, of course, expected to incur, or reap, any losses, or gains, that result from the time of the initial transaction, but a two percent redemption fee is too punitive. I think the SEC has not given adequate consideration to the psychologically negative impact that redemption fees have on investors that cause them to remain in a fund when they have made a timing or other mistake. Redemption fees, because actual trading costs are so low, should be much lower, not higher.
A mutual fund that pays two percent to buy and sell shares or one percent for each side of the transaction should not be rewarded by investors with the investors capital. Mutual funds, and the SEC, have yet to substantiate that a two percent redemption fee equates with the actual costs of trading.
Finally, redemption fees appropriately go to the fund and not to the fund management. How much this contributes to the performance of a mutual fund is not disclosed.
James E. Grant, CPA