The Fee That Makes You Money

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Mutual fund fees are bad, everyone knows that. They undermine compounding, dramatically reducing returns over the long term.

Except in cases when fees are good. Then they actually improve returns — by as much as 3.27 percentage points a year.

Confused? That’s understandable, because recent research by three academics counters the common wisdom. It shows that a certain type of fee, the redemption fee, can improve some funds’ results by discouraging short-term investing. Funds that invest in small- and micro-capitalization stocks got the biggest benefit, while the fees did little to improve results of funds investing in large-cap stocks.

In their paper Redemption Fees: Reward for Punishment, the three professors report that redemption fees reduce some funds’ turnover, or the pace at which shares are bought and redeemed by investors. Heavy turnover can force managers to buy and sell stocks at inopportune times. Less turnover allows them to be more judicious.

Funds with high turnover also have to maintain large cash reserves for redemptions, reducing money available for investment. And they incur larger transaction costs, such as commissions. While the study did not address the issue, high turnover can also trigger bigger tax bills.

The paper’s authors are Michael S. Finke and David Nanigian of Texas Tech University, and William Waller of the University of North Carolina at Chapel Hill.

Redemption fees are charged to investors who redeem shares shortly after buying them. Many funds, for example, charge a fee equal to 2% of the sales proceeds of any shares held for less than two months. The fee is meant to discourage in-and-out trading by speculators, which many fund companies believe is harmful to long-term investors.

The researchers studied more than 5,000 funds, finding that redemption fees grew in popularity during the past decade. Only 7.7% of funds had such fees in 2003. By 2007 about 25% of funds had them.

In 2007, about 78% of funds that had redemption fees charged 2%, the maximum allowed by federal regulation. Nearly 87% of funds with fees imposed holding periods of three months or less.

The fees are most common in funds that are smaller and those that invest in small-company stocks, which tend to be less liquid than large-company stocks. Low liquidity often results in larger spreads between bid and asked prices, raising the costs of frequent buying and selling.

The larger the fee and the longer the holding period, the more likely the fund will outperform similar funds without fees, the researchers found. Funds charging the maximum 2% fee for a holding period longer than two months beat their no-fee peers by 3.27 percentage points a year.

“Mutual fund redemption fees can protect long-term investors by imposing a penalty on investors who reduce fund performance by trading frequently,” the researchers conclude.

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