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Redemption Fees Signal Mutual Fund Outperformance?

| | Posted in: Mutual/Hedge Funds

Should investors avoid mutual funds that charge redemption fees, or is there a good reason to accept this explicit hit to liquidity? In other words, do these fees protect underperforming fund managers or long-term investors? In their recent paper entitled “Redemption Fees: Reward for Punishment”, David Nanigian, Michael Finke and William Waller study the impact of short-term redemption fees on long-term fund performance based on fee size and duration (effective time interval of the redemption fee after purchase). Using monthly after-tax returns for a very large sample of open-end US equity mutual funds over the period July 2003 to May 2007, they conclude that:

  • The percentage of U.S. equity mutual funds charging a redemption fee increases from 3.9% in 2003 to 14.6% in 2007.
  • Among funds imposing a redemption fee, the proportion with fee durations one year or longer falls from 29% in 2003 to 5.5% in 2007, while the proportion with fee duration one month rises from 14.4% to 48%.
  • Funds with redemption fees tend to be small in size, have low expense ratios, favor value over growth and lean toward small capitalization stocks.
  • Redemption fees mostly indicate fund outperformance, especially for fee durations greater than one month, as follows:
    • Funds with small redemption fees and long durations outperform funds with no redemption fees by about 3% per year.
    • Funds with large redemption fees and long durations outperform funds with no redemption fees by about 1.2% per year.
    • Funds with small redemption fees and short durations outperform funds with no redemption fees by about 0,9% per year.
    • Funds with large redemption fees and short durations underperform funds with no redemption fees by about 1.1% per year.
    • Funds that levy the full 2% fee allowed by the SEC tend to underperform funds with comparable durations but lower fees.

In summary, properly structured mutual fund redemption fees tend to protect long-term investors by penalizing frequent traders. Small redemption fees of long duration are optimal for long-term investors.

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