Welcome back to another edition of Foolish mutual fund basics. This time, we're leaving behind the back alleys, where multiple share classes rob your returns, for the friendlier confines of fund redemption fees. Ready to get started? Good.
What it is
Wait a minute. Fees? Friendly? Aren't fees bad? Not always.
Rewind with me to September 2003. That's when New York governor Eliot Spitzer, then Attorney General, first braced for a fight with fund operators Bank of America (NYSE: BAC ) and Janus Capital (NYSE: JNS ) , among others. Each was accused of playing favorites with big-money clients by allowing them to trade more frequently than regular investors.
But of course, it was more than that. By timing trades over short periods, big clients racked up millions in profits, and left funds and their retail investors to pay huge transaction fees. (For more on this, take a tour of the turnover ratio.)
Foolish colleague Bill Mann, who covered the scandal when it first broke, put it best, "If PetroChina (NYSE: PTR ) announces a big dividend increase, its shares trading in China react. But it's still nighttime in the U.S., so timers have the ability to jump into funds on one day, wait for the price to react to the news, and then get out."
And retail investors? After learning the truth, the funds they had looked upon like Heidi Klum on the Sports Illustrated cover turned out to be Joan Rivers before the makeup.
How it works
Enter redemption fees, which, like an expense ratio, charge traders a percentage of assets. But that's where the similarities end. Motley Fool Green Light co-advisor Shannon Zimmerman, who leads our Champion Funds service, explains:
"Unlike loads or expense ratios, redemption fees are kicked back into the fund itself, returned to continuing, long-term shareholders as a way of, among other things, deterring market timers and defraying transaction costs," Shannon wrote in the May 2005 issue of Champion Funds.
Practically, this means that the net asset value of the fund, or NAV, will be largely unaffected by the trader who changes funds more frequently than Gisele Bundchen swaps outfits during a Victoria's Secret photo shoot.
Without redemption fees, the higher transaction costs could lower total fund assets, reducing the NAV and hurting investor returns.
Go under the hood
You'd think that would have the best fund managers in the business salivating to add redemption fees. Surprisingly, that's not the case. Many of Shannon's best picks, such as Bridgeway Small-Cap Value (FUND: BRSVX ) , allow traders to have their way.
Your funds may be similarly lenient. To find out, check with Morningstar.com. Clicking the "Fees & Expenses" tab will show you everything investors are required to pay, including redemption charges.
Follow the money
When it comes to stocks, day trading is hazardous only to your portfolio. When it comes to funds, day trading is hazardous to everyone who has a stake. That's why, if you're a long-term investor, it's in your best interest to seek out funds that use redemption fees to discourage the give-me-a-triple-shot-of-espresso fund-slingers.
Interested in more moneymaking advice? Consider Green Light. Therein, Shannon and co-advisor Dayana Yochim show you how to unlock the hidden fortune inside your paycheck. There's $686 worth of tips in the January issue alone. Click here to get your copy and 30 days of free access to the service. There's no obligation to subscribe.
Interested in more mutual fund basics? Your digital chariot awaits:
- What is an expense ratio, anyway?
- Turn over the rock on portfolio turnover.
- Sometimes, five-star funds provide one-star returns.
- Stop your broker from sharing so much.
- Find out if you're overpaying to invest.
- Take an exotic tour of fund categories.
- It can be hip to be R-squared.
- Is your fund manager sweetening your returns?
- Give the tax-man a stiff-arm.
Bank of America is an Income Investor recommendation.
Fool contributor Tim Beyers, ranked 996 out of more than 21,200 in Motley Fool CAPS, our investor intelligence database, writes weekly about personal finance and investing basics. Have a Foolish money tip? Tell him. Tim didn't own shares in any of the companies mentioned in this article at the time of publication. Get a peek at everything he's invested in by checking Tim's Fool profile. The Motley Fool's disclosure policy won't redeem your returns.