Funds Add Exit Fees to Slow Rapid Trading

With many stock mutual fund investors increasingly jittery about the market, fund companies are stepping up efforts to discourage rapid trading, mainly by slapping fees on shares sold relatively soon after purchase.

Putnam Investments, for example, is sticking a 1% exit fee on shares of its Putnam Emerging Markets and Putnam Asia Pacific Growth funds bought after Thursday if they are sold within 90 days.

Fidelity Investments this week will initiate a 0.75% fee on shares of its Mid Cap Stock fund that are bought and sold within 30 days. The fund was one of the firm’s bestsellers last year.

American Century, meanwhile, plans to introduce its new Avanti Fund with an especially restrictive exit fee: It would apply to investors who sell shares of the growth-stock fund within five years of purchase. The fund, whose filing awaits approval by the Securities and Exchange Commission, also would carry an unusual “redemption-in-kind” feature: Investors who fail to meet the holding-period requirement must give 15 days’ notice when selling--or accept shares of stock from the portfolio rather than cash.

Vanguard Group, Invesco and many other firms use exit charges to ward off market timers, particularly on sector, small-cap and international funds where traders tend to flock, or where their activity can cause liquidity problems for portfolio managers. Fees paid go back into the funds.

The small minority of fund traders can drive up costs for remaining shareholders, fund companies say. A recent study by the Investment Company Institute, the industry’s main trade group, found that in most years three-fourths of any given fund’s shareholders make no redemptions.

“Market timers are hit-and-run drivers whose victims are stuck in a fund with lower performance,” said Chris Doyle, spokesman for Kansas City, Mo.-based American Century. He noted that portfolio managers can become hamstrung if they must keep cash levels high to gird for outflows, or if they must sell some stocks and avoid buying others to pay fleeing investors.

Stock sales spurred by redemptions also can lead to taxable capital gains distributions for the remaining shareholders.

Of the 12,100 funds in Morningstar Inc.’s database, 738, or 6.1%, are allowed by charter to impose exit fees. Although Morningstar’s data do not track trends in the fees, industry consultants agree that redemption charges are becoming increasingly common.

They also are effective, even though the charges may seem small--ranging from 0.1% to 3% of the dollar sum redeemed.

Avi Nachmany, analyst at the New York-based fund consulting firm Strategic Insight, said one firm told him its monthly rate of redemptions on a prominent international fund plunged from 25% of assets to a much more manageable 2% after it added an exit fee.

But the charges are no cure-all.

“Is 1%, for instance, enough to be a discouraging factor?” said Geoff Bobroff, an industry consultant based in East Greenwich, R.I. “Maybe not if my fund has already jumped 50%. But it’s a speed bump.”

For their part, investors who specifically try to time market swings via funds say the fees are a deterrent--to a degree.

“We may go elsewhere or we may decide it’s worth the extra pain to pay Fidelity’s fee, what you might call the cost of doing business,” said editor Ron Rowland of All Star Fund Trader, a timing strategies newsletter based in Austin, Texas.

Rowland said he uses Fidelity’s lineup of 40 Select sector funds, even though the funds impose fees of 0.75% on sales done within a month of purchase. Rowland likes the funds because they offer active management rather than an index approach, and they provide a wide choice of industries. He aims to hold the funds for about two months to dodge the fees.

But he also has begun using funds from indexing specialist Rydex--one fund company that welcomes rapid traders. It imposes no redemption charges on its 17 sector funds.

The SEC typically caps redemption fees at 2%, because the Investment Company Act of 1940 requires that fund shares be freely redeemable. But in “extreme circumstances” temporarily higher charges may be allowed.

Foreign funds, especially single-country funds, are prime turf for timers.

Indeed, Nachmany said “the increasing phenomenon of market timers trading the time zone” is a key reason for the proliferation of exit fees. Traders might, for example, buy a Japanese stock fund after it prices at 4 p.m. New York time if the Nikkei stock index is simultaneously soaring the next day in Tokyo. The idea: Dump it in 24 hours for a quick profit.

Brian Mattes, spokesman for Valley Forge, Pa.-based Vanguard, notes that foreign markets also have higher trading costs than the U.S. market. Vanguard has an exit fee on its Emerging Markets Stock Index fund as well as on several domestic funds.

In Putnam’s case, this is the first time the firm has used redemption fees, said spokesman Matthew Keenan. But the Boston company has taken other steps over the years to rein in short-term traders, such as sending “warning letters” and refusing purchase orders from known timers, he said.

Vanguard also uses various tactics in the war against timers, including limiting shareholders to two “round trips” in a fund per year and prohibiting phone exchanges on certain funds. It also plans to begin offering exchange-traded versions of its funds, which should keep the traders happy--and away from the buy-and-hold masses, Mattes said.

“Redemption fees are basically a last resort,” he said.