What Is a Redemption Fee?
A redemption fee is a fee charged to an investor when shares are sold from a fund. This fee will be charged by the fund company and then added back to the fund. This fee may also be known as an exit fee, market timing fee, or short-term trading fee. It is typically instituted within a specified time frame when an investor sells shares.
- A redemption fee is a cost borne by investors when they sell certain shares before a designated time period has elapsed.
- When the redemption fee is collected, it goes directly back into the mutual fund where it can be invested in the fund's portfolio.
- Shareholders pay a redemption fee in accordance with their amount of shares.
- Redemption fees are imposed as a penalty to help to discourage short-term trading.
How a Redemption Fee Works
A redemption fee is often associated with a mutual fund. When an investor sells shares from the fund, a redemption fee can be charged by a fund company. Mutual funds are typically part of a long-term investment strategy and they are not usually intended for short-term trading or gains from market timing. In addition, they are spread across the fund shareholders in accordance with the amount they have invested. This setup promotes fairness surrounding these fees.
For this reason mutual fund timing, although legal, is a frowned-upon practice that usually results in an additional charge for the investor. To discourage short-term trading, fund companies will typically charge a redemption fee within a specified time frame. Most fund companies use a time frame of 30 days. If an investor exits the fund within 30 days of their initial purchase then a redemption fee could be charged. The redemption fee is most often charged to investors exiting (i.e. selling) their position, as opposed to charging an up-front fee that may discourage deposits.
Before acquiring shares in a mutual fund, check on redemption fees and make sure to avoid paying the fee by not engaging in short-term trading.
Redemption fees can minimize short-termism as they increase the transaction costs of repeatedly buying and selling fund shares. Investors are typically not charged for redeeming shares of the investment if it’s outside of the designated minimum holding period, for instance a year or six months. With that said, it’s important to be aware of any redemption fees and time frames associated with them.
Redemption fees are necessary to protect other investors from higher transaction costs. Active short-term redemptions lead to two significant issues for the fund manager including:
- The fund is required to maintain higher cash positions to accommodate sell orders.
- Short-term trading increases the overall operating costs of the fund.
Therefore, in order to keep cash positions and operating expenses lower, the fund may enact a redemption fee.
Redemption Fees vs. Back-End Sales Loads
Back-end sales loads are paid to intermediaries and structured as part of a share class’s sales commission schedule. These charges can be a static percentage fee or they may be contingent deferred. Static back-end sales loads are in effect for the duration of a holding and charged as a percent of assets transacted. Static back-end sales loads are typically lower than front-end fees, averaging approximately 1%. Contingent deferred back-end fees decrease over the life of the investment. They may even expire after a specified time period, in which case a share class could be eligible for a reclassification.
Redemption fees differ from back-end sales loads since they are associated with the fund’s annual operating expenses. Mutual fund companies integrate redemption fees into their fee schedules to mitigate short-term trading of mutual fund shares. Redemption fees are typically only in effect for a specified time period, which can range from three months to approximately one year. If an investor does choose to redeem shares during the specified time period, the fee helps to offset the transactional expenses associated with the redemption and also helps to protect other investors from higher per share expenses overall.
Example of a Redemption Fee
Mutual fund investing can involve numerous fees throughout the investment duration. Other fees involved may include sales loads, 12b-1 fees, and account service fees. Investors should ensure they understand all fees involved before buying and selling a mutual fund.
Vanguard mutual funds do not broadly include redemption fees however they are required in some of the fund company’s mutual funds. The Global ex-U.S. Real Estate Index Fund Investor Shares (VGXRX) is one example. This fund has a purchase fee and a redemption fee to support the expenses of the fund. VGXRX charges a purchase fee of 0.25% and a redemption fee of 0.25%.