Redeeming Qualities to Early-Exit Fees? Sometimes

Stephen L. McKee wanted to sell out.

After just a few weeks in the Fidelity New Markets Income Fund, an emerging-markets bond fund, McKee thought he had made the wrong call and was ready to move on.

The only problem was a redemption fee, a 1% charge levied against investors who leave the fund within 180 days.

McKee didn’t want to pay it, so he let the money ride and planned the timing of his eventual escape.

“While I was staying in to beat the fee, the fund took off,” says McKee, editor of the Texas-based No-Load Mutual Fund Selections & Timing newsletter. Fidelity New Markets Income is up more than 34% in the last 12 months. “I generally don’t like redemption fees, but this time it worked for me.”

Short-term redemption fees actually are designed to work for the fund, not the customer. They represent a punishment to investors who dump a fund quickly, generally within three months to a year.

The fees are designed to discourage market timers--investors who jump in and out hoping to catch only the best prices, and who also increase fund costs. Such fees are needed by small or esoteric funds because a wave of redemptions could force a disastrous sale of assets.

Although no one in the industry has kept tabs on the spread of redemption fees, it appears that they are getting more popular.

Part of that growth can be traced to the creation of more funds investing in sensitive arenas, from tiny stocks to countries such as Russia.

The exit fees may also be a backlash to the growth of the so-called fund supermarkets, where a brokerage firm sells funds from many fund companies. Critics charge that these networks encourage trading and market-timing by making it easy to move from one fund to the next; redemption fees give investors a reason to stick around.

Indeed, exit penalties may be one way for some fund companies to try to teach investors a lesson. A redemption fee creates an incentive for fickle investors to lengthen their time horizons and practice the kind of long-term strategy that every fund company preaches.

“It’s kind of like a fund setting public policy, saying, ‘We believe in long-term investing, and anyone who is short-term in nature should pay a price for that way of thinking,’ ” says Robert Powell, editor of Mutual Fund Market News, a Boston-based newsletter. “Maybe they figure some short-term investors will come around to [the fund companies’] way of seeing things.”

Clearly, fees that frighten rapid-fire traders away from small or unique funds--including single-country, single-state municipal bond and sector funds--protect investors by dampening volatility. But market timers really can’t hurt mainstream funds, making some of this fee activity look funny. There is no good reason, for example, why several Standard & Poor’s 500 index funds should ding investors who bail out in less than a year.

Of course, fund families insist their only message is that market timers are not welcome.

For individuals, whether short-term fees are distasteful or have merit depends as much on point of view and investment strategy as it does on the amount of the fee being charged.

If your fund imposes a short-term redemption fee, you’re happy once the penalty period expires. The fee’s potential to quiet volatility and keep new investors in line is a good thing.

If you are just buying shares and are considering a fund with a redemption fee, however, the idea merits a second thought.

“A short-term redemption fee is one other decision to make before you get serious about buying a fund,” says Bruce Katz of Zweig/Avatar Capital Management in New York and president of the Society of Asset Allocators and Fund Timers. “If you know a fund has one, you can plan for it. You can decide if the fee is justified and how confident you are about sticking with the fund long enough so that the fee is a non-factor.

“If you are the kind of investor who moves money around, remember that there is almost always an alternative out there without a fee.”

And if you are already in a fund that has a short-term redemption fee, weigh the cost of getting out against what might happen if your money stays in. If the penalty is 1% or 2% and you need to wait only 30 days more to avoid paying it, determine whether your alternative can recoup that cost in the same amount of time.

You might even get lucky, like McKee.

“Redemption fees can work both ways,” he says. “If they stop you from making hasty moves, that’s not such a bad thing. But if you buy, say, an Asian fund right before a currency plunge that makes you want to get out, that redemption fee is going to add insult to injury. That’s why if a fund is charging one of those fees, you need to think it’s pretty great before you go buy it.”

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Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, P.O. Box 2378, Boston, MA 02107-2378.

* WHO CHARGES THEM

To find out which funds impose redemption fees, check the notations in the special mutual fund tables in this Tuesday’s Wall Street, California pages.