Watch out: More funds are introducing them.
To combat the mutual fund timing problem, the
Securities and Exchange Commission (SEC) has proposed that mutual fund
companies assess shareholders a short-term redemption fee. In other
words, if a shareholder buys and then sells shares in a fund within a
short period of time, the SEC is strongly encouraging the fund company
to assess the shareholder a "redemption fee." At this time, the fee is
voluntary and varies by fund company.
The redemption fee does not go back to the fund
company, but rather goes to the fund itself. Short-term redemption fees
are designed to reimburse the fund for the direct and indirect costs
that the fund pays to redeem short-term investors' shares, as well as
to discourage market-timing practices. In the past the cost of
accommodating frequent traders was borne by the fund's long-term
investors.
"Fund companies love charging redemption fees
because it helps fund returns. This is especially true when redemption
fees exceed the actual cost of shorter-term investing to the fund."1
Since performance figures drive the marketability of a fund, redemption
fees can only add to those quoted returns.
Clearly, the SEC's intent is to protect the
interests of each investor in the mutual fund. However, by not
standardizing the process with its own formula, the SEC is further
complicating the matter by directing each mutual fund company to
determine how the fee is calculated and what is considered "short
term."
The root cause of the mutual fund timing problem is
two-fold: Mutual fund prices (NAVs) are predictable, and in the absence
of transaction costs, that predictability is exploitable.2 Fund price
predictability is well documented, dating back to the Cowles and Jones
(1937)(3) statistical ratio. The Cowles-Jones Ratio proposed a
statistic for testing market efficiency based on the frequencies of up
movements relative to down movements. Other researchers have also
identified several patterns of predictability: a weekend effect, a
January effect and a post-earnings announcement drift.
Mutual fund prices are predictable because (1) the
prices of the underlying securities in the fund's portfolio are
predictable, and (2) mutual funds often use "stale prices" of
securities that have not recently traded to compute the NAV. This
situation is ripe for the arbitrageurs who exploit this predictability.
Mutual fund shares are a compilation of a portfolio
of assets, which in turn makes trades in the mutual fund shares
indirect trades in the underlying assets. To arrive at a fund's net
asset value (NAV), fund companies base the value of the shares in the
fund on the closing price (last trading price) of the underlying
securities in the fund.
However, the value of the fund shares may not
reflect an accurate price for the underlying securities. For example,
fund investors can feasibly make their trading decision as late as 3:55
PM. However, many of the underlying assets held by the fund have long
since experienced their last transaction of the day, making the mutual
fund's price stale since the underlying securities' closing prices may
not fully reflect the day's market news.(4)
You may wonder why mutual funds can be exploited and
individual securities generally are not exploited. The answer is
simple.
The profit opportunities that arise from predictable
NAVs are often greater than mutual funds' transaction fees. By
comparison, transaction costs for individual securities more than
offset the potential profits from trading strategies devised to capture
the predictability. In an attempt to engineer a level playing field,
the SEC is encouraging fund companies to impose redemption fees on
short-term trades that are sufficiently large enough to offset
potential gains from market timing the funds.
Redemption fees add costs and restrict liquidity.
Within retirement plans, these disadvantages greatly undermine the
benefits of investing in mutual funds.
Given the fact that plan participants are constantly
making contributions to their retirement accounts through payroll
contributions, which in turn are used to purchase additional fund
shares, redemption fees represent a harsh assessment for these
participants. As plan participants adopt investment strategies
practiced by institutional investors-that is, investing their
contributions by allocating their money among the asset classes
according to an asset allocation model (often referred to as a managed
account)-redemption fees impose a harsh penalty on the participants
when it is necessary for them to rebalance their portfolios.
A managed account necessitates that the account be
rebalanced at least quarterly in order to maintain the portfolio in
alignment with its target composition, i.e., the asset allocation
model. In other words, a participant may need to sell enough of an
overweighted asset and reinvest the money in the remaining assets to
return the portfolio to its target composition.
Since plan participants are constantly investing
money in their retirement accounts, no matter when a participant
initiates a rebalancing the participant will evidently be hit with some
redemption fees. Furthermore, since rebalancing is fundamental to the
entire process of managed accounts, most service providers who offer
asset allocation models are rebalancing participants' accounts
automatically on a quarterly basis.
Of course, other options have been considered and
debated at length regarding the appropriate solution to the mutual fund
timing problem. Some proponents argue that fair-value pricing would fix
the problem, while others advocate next-day fund pricing.
The objective of fair-value pricing, as defined by
the SEC, is to adjust the prices of the fund's underlying securities
for staleness. In a letter from the SEC to the Investment Counsel
Institute (ICI), the SEC states, "Ascertaining fair value requires a
determination of the amount that an arms-length buyer, under the
circumstances, would currently pay for the security. Fair value cannot
be based on what a buyer might pay at some later time."
In principle, fair-value pricing would eliminate
fund timers' profits without imposing substantial costs on fund
investors. Despite its attractiveness, fair-value pricing involves
numerous complexities, which most researches agree will introduce its
own artificial source of predictability in NAV.
Without a perfect methodology for fair-value
pricing, there will be times when pricing vendors will be forced to
adjust too little and times when the vendors will adjust too much. "To
the extent that some arbitrageurs know more about the true relation
between available information and fair value than the pricing vendor,
they will exploit it." (5)
Another option is to apply next-day pricing to
mutual funds. Proponents of next-day pricing explain that this option
effectively removes the predictability in mutual fund NAV by placing a
one-day gap between the time an investor decides to make a transaction
and the time at which the transaction is "priced." Next-day pricing
completely eliminates the usefulness of an individual's ability to
predict next-day fund prices.
The virtues of this approach are its simplicity and
explicit low cost to investors. However, the magnitude of the cost to
implement this strategy have not been explored, and it clearly
undermines the promise of liquidity that investors have come to expect
from mutual funds.
Given all the solutions, the SEC obviously seeks to
correct the imbalance by its encouragement of redemption fees. However,
participants in 401(k) plans may feel that this solution is wholly
unfair to them.
Redemption fees can only discourage plan
participants who adopt a managed account approach to investing. As
mentioned previously, this strategy of investing involves a periodic
rebalancing of the portfolio when the allocation model becomes
unbalanced.
A portfolio can become "unbalanced" when assets in
the portfolio perform extraordinarily well, or conversely, perform
poorly. This throws the portfolio out of balance, since the weighting
in the various asset classes is not in alignment with the allocation
model. To return the portfolio to its target composition, the
participant must sell enough of the overweighted assets and buy enough
of the underweighted assets to bring the portfolio back in alignment
with the criteria for division among the asset classes for the model.
Prudently, a participant should rebalance his or her
portfolio at least quarterly. For participants invested in mutual
funds, the impact of redemption fees during this rebalancing process
has not been given any obvious consideration.
Since it's indisputable that redemption fees are
becoming entrenched within mutual funds at an accelerated pace, an
obvious solution to avoiding redemption fees altogether is to invest in
exchange-traded funds (ETFs), which trade like stocks and are
completely free of redemption fees. Maybe its time for plan sponsors to
give more consideration to changing the investment options in their
retirement plans to ETFs. As an instrument that could change the scope
of investing in 401(k) plans, it is inevitable that more and more money
will pour into ETFs.(6)
Darwin Abrahamson is the founder and
CEO of Invest n Retire LLC, a record keeping service provider for
401(k) plans in Portland, Ore. (www.investnretire.com)