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What Is a Redemption Fee?

By Motley Fool Staff – Jun 30, 2016 at 12:02AM

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Many mutual funds impose this charge on certain investors. Find out if you're at risk.

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Redemption fees are charges that mutual funds impose on some of their investors when they sell their mutual fund shares. Because traditional mutual funds are designed primarily to help long-term investors, the companies that manage mutual funds want to discourage frequent traders and market-timers from buying and selling shares repeatedly over short periods of time. Redemption fees serve that purpose by charging short-term trading fees on those who trade more frequently than the fund wants. To avoid redemption fees, you typically have to hold onto your fund shares for a slightly longer period of time.

Why redemption fees make sense

Mutual fund companies justify charging redemption fees by appealing to investors' sense of fairness. Whenever you buy or sell mutual fund shares, the fund manager bears the administrative costs of accounting for your trade and either buying additional assets with your deposit or selling assets to generate cash proceeds to pay you. In addition, purchases and sales trigger record-keeping requirements and often require the fund manager to provide an electronic record or mail a paper confirmation.

These costs are spread across all fund shareholders in proportion to the amount they have invested in the fund, even if only a few shareholders are actually responsible for the added costs. The redemption fee attempts to make frequent traders pay for the added costs they force the fund to incur. The fund doesn't want to discourage deposits, so the redemption fee puts the charge on traders when they try to exit. Any money collected in redemption fees goes back to the mutual fund rather than to the fund manager, with the idea that the fee reimburses other shareholders for the costs the fund bore in dealing with the short-term trader.

What redemption fees look like

The amount of a redemption fee varies among funds, but typical fees amount to between 1% and 2% of the transaction amount. The Securities and Exchange Commission limits redemption fees to no more than 2% in most situations.

Time periods in which redemption fees apply also vary. Some redemption fees apply for as little as 30 days, meaning that you can buy and sell on roughly a once-monthly basis without triggering the fee. Other common periods include 90 days, 180 days, or one year, although some funds charge fees even for holdings you've owned for several years.

If you're a long-term investor, then redemption fees work in your favor, and you should appreciate mutual funds that impose them. For frequent traders, however, redemption fees are something to watch out for and avoid when possible.

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