WHAT IS 'Reallowance'

A reallowance is a fee paid by an underwriting group to a securities firm that is not part of the underwriting syndicate, but still promotes shares of the offering to its own clients.

The fee provides an incentive to broker-dealer firms to sell shares to its own client base, with the reallowance typically calculated as a percentage of the underwriting spread the selling syndicate negotiates.

BREAKING DOWN 'Reallowance'

A reallowance may be offered by a syndicate when it is willing to part with a portion of the underwriting spread because of uncertain investor demand. For example, if that spread for a new issue priced at $30 is $2.50, the reallowance may range from 50 cents to 75 cents, depending on demand for the issue and the difficulty in placing the offering.

Regulators require that such reallowances be disclosed in securities offering documents so that investors know in advance of such incentives.

Why Institutions Offer Reallowances

Mutual funds often use reallowances as an added incentive to encourage brokers and dealers to sell shares of these funds to clients. Although these fees should be disclosed in the fund’s regulatory documents, and usually do not add to the price of the shares, the practice can encourage investment advisers to promote one fund over another. Given a choice of two funds equally appropriate to an investor, extra incentives a broker or dealer receives from one underwriting syndicate may sway a decision on which fund to recommend.

Although reallowances don’t impact the price of new shares to investors, they do represent how various sales charges or loads are distributed and allocated to participating brokerage firms or dealers. The practice can be controversial if investors aren’t aware that selling brokers are receiving extra compensation. 

Reallowances are common when funds are first introduced by new companies that have not yet established a relationship with the investment community. This practice encourages brokers to review them more closely as possible opportunities for clients. And even well-known mutual fund companies may allocate reallowances for funds that feature new investment strategies or approaches to asset allocation. And in some cases, institutions offer reallowances when introducing specialized mutual funds in new sectors, for example in emerging technology, internet media and alternative fuel sectors.

There can also be a seasonal trend in reallowances. Because investors can make tax-deductible IRA contributions after the end of a tax year, but before the April 15 tax filing deadline, many choose to make contributions during the first three months of the year to reduce their tax liability for the previous year, creating additional investor demand for investment opportunities.

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