Not every fee is bad.
Now that many investors are returning to stock mutual funds for the first time in years, they're focused on minimizing their expenses. It's one of the easiest -- and most powerful -- steps they can take. But one fee they might encounter shouldn't be a turnoff, researchers say. Instead, it's actually an encouraging sign.
It's the redemption fee that some mutual funds charge to investors who quickly jump in and out of a fund. Researchers have found that funds with redemption fees tend to do better than those that don't, largely because they discourage short-term traders -- and the additional costs that they may bring -- from entering.
The fee applies only during a preset time period: Investors who withdraw money within, say, two months of their initial investment get charged. The fee can be as much as 2% of the amount withdrawn, and the proceeds go to the fund and its remaining investors.
"We will never get rid of it," says Bill Mann, portfolio manager at Motley Fool's mutual funds, all of which have redemption fees. "It is a force for good."
Among the funds Mann runs is the Motley Fool Great America fund (TMFGX), which has a five-star rating from Morningstar.
Redemption fees are limited in number. Morningstar says 13% of mutual funds have them. But where investors will see them most often is among stock mutual funds.
Roughly one in four of all foreign stock mutual funds has a redemption fee, according to Morningstar. Among funds that focus on a specific sector or industry, such as technology or utility stocks, 26% carry a redemption fee.
The Al Frank fund (VALUX), for example, is a large-cap value fund that charges a 2% fee on withdrawals made within 60 days. It wasn't always so, says John Buckingham, the fund's manager.
The fund didn't charge a redemption fee when it began in 1998. But after it posted a return of 60.4% in 1999, many investors noticed the big number and came calling. Some were more interested in making a quick buck than a long-term investment.
"If someone gives you $1 million and redeems it two days later, that wreaks havoc on your portfolio," Buckingham says. "Do I spend the money? Do I not spend the money? Do I sit in cash?"
It became even more difficult around 2003, when a newsletter recommended buying into the fund. Buckingham says he saw $50 million to $60 million come in over the span of a month.
"Four months later, the newsletter said it was time to redeem, time to find another fund," Buckingham says. "If someone wants to redeem $1 million from a fund, I can't say I'll pay you a week from Tuesday."
Such quick hooks of cash hurt mutual funds in several ways. It may force managers to sell stocks to raise the cash that they need to return to redeeming shareholders, and that means increased trading costs. The need to raise cash quickly can also push managers to be biased toward stocks that are easier to trade, such as large-cap companies over smaller ones. Those may not be the stocks that the manager prefers.
But the biggest reason that short-term traders hurt mutual funds is that they force managers to hold onto more cash than they otherwise would, says Michael Finke, a professor and director of retirement planning and living at Texas Tech University.
He presented a paper entitled "Redemption Fees: Reward for Punishment" at the 2010 Morningstar Ibbotson conference. He and the paper's co-authors found that funds with redemption fees tend to have better returns than funds that don't, with a difference in performance of about 1% to 1.4% a year.
After mutual funds institute redemption fees, the researchers found that cash as a percentage of a fund's total holdings dropped by up to 1.02 percentage points. That may not sound like much, but mutual funds have millions or billions of dollars in total assets. One percent of $1 billion is $10 million that a manager can invest in stocks rather than cash.
And over the long term, stocks return more than cash, which means mutual funds that hold more stocks and less cash will have better performance over the long term.
"If you look at the funds that have a redemption fee, they tend to attract a clientele of long-term investors," Finke says.
To be sure, Finke says the most important thing he considers for a mutual fund is its expense ratio. The lower it is, the better. But after that, all else being equal, he says investors should prefer funds that have a redemption fee.
"I invest in low-expense mutual funds," he says, "that just happen to also have redemption fees."
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