When Fees Can Help Your Fund

Christine Benz: Hi, I'm Christine Benz from Morningstar. I'm here at the Morningstar Ibbotson Conference with Michael Finke. He is an Associate Professor and Ph.D. Coordinator at Texas Tech. Michael, thanks for being here today.

Michael Finke: Thank you.

Benz: So you presented some interesting research yesterday showing some correlation with funds that have redemption fees and relatively better performance. Can you give us a quick overview of what you found?

Finke: That's right, redemption fees have become a lot more popular, especially after the mutual fund crisis in 2003. We saw a change from about one in 15 mutual funds to actually about one in four mutual funds imposing redemption fees. That's a pretty large change among mutual funds. There hasn't been a lot of research that describes whether or not redemption fees actually had an impact on performance.

Now, we found that they did have an impact on reducing turnover in mutual funds and on reducing cash holdings, both of which we know have an impact on performance. When we actually looked at performance, the performance improvements among funds that had redemption fees really occurred among those funds that had a large redemption fee, it's capped at 2%...

Benz: Right.

Finke: ...and funds that had a longer duration redemption fee of greater than two months. They mainly occurred within small and micro-cap stocks, which makes a lot of sense because they tend to invest in more illiquid securities. Those types of securities having lower turnover, fewer redemptions, actually can have an impact on performance.

Benz: Right. So if the manager's not having to anticipate redemptions and not having to sell stuff that he or she rather not sell that could tend to lead to better performance.

Finke: That's right. These types of liquidity motivated trades tend to be a lot more harmful, especially among funds that hold illiquid securities.

Benz: Right. Now, you also indicated though that you noticed this phenomenon primarily in small and especially in micro-cap funds, but not so much in the large-cap space where the impact wasn't as great. Can you tell me about that?

Finke: That's right. It's basically consistent with the theory that even if investors are moving in and out of some of these more liquid types of mutual funds, it doesn't tend to have that much of an impact on performance. So we didn't see that much of an impact of redemption fees, even if they're sort of a longer duration at a higher magnitude on those more liquid mutual funds.

Benz: OK. So if I'm an investor looking to think about how to include this data in my mindset when selecting funds, it sounds like small and micro-cap space might be an area where I'd want to look for a fund with a redemption fee.

Finke: That's right. There does seem to be a small stock effect. You can take advantage of the small stock effect by investing in small and micro-cap mutual funds. When you're selecting small and micro-cap mutual funds, it's probably good to search for ones that have a redemption fee and especially a redemption fee with a longer duration, more than two months.

Benz: Right, sounds good. Thank you, Michael.

Finke: Thank you.

Christine: Interesting research.

Finke: Great, thanks.