What Is a Redemption Fee?
A redemption fee is a fee charged to an investor when shares are sold from a fund. This fee, also known as an exit fee, market timing fee, or short-term trading fee, is charged by the fund company and then added back to the fund. Typically, it only applies when shares are sold within a specified time frame.
- 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 a fund, a redemption fee can be charged by the company that runs it. To promote fairness, they are spread across the fund's shareholders in accordance with the amount they have invested.
Mutual funds are typically part of a long-term investment strategy and are not usually intended for short-term trading or gains from market timing. 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. Usually, this is 30 days, although in some instances the time period may stretch to 90 days, 180 days, one year, or more.
The redemption fee is often charged to investors when they exit or sell their position. Charging the fee up-front is rare and risks discouraging deposits.
Investors are typically not charged for redeeming shares of the investment if it’s outside of the designated minimum holding period.
Benefits of Redemption Fees
Redemption fees can minimize short-termism as they increase the transaction costs of repeatedly buying and selling fund shares. In many cases, they are viewed as a necessary evil to protect other investors from higher transaction costs.
- The fund is required to maintain higher cash positions to accommodate sell orders.
- Short-term trading increases the overall operating costs of the fund.
Redemption fees are applied to keep a fund's cash positions and operating expenses lower. By charging an investor who chooses to redeem shares during the specified time period, the fund is able to recoup the transactional expenses associated with the redemption and protect other investors from having to foot the bill via higher per share expenses.
The Securities and Exchange Commission (SEC) generally limits redemption fees to 2% of the sales amount.
Redemption Fees vs. Back-End Sales Loads
Static back-end sales loads are in effect for the duration of a holding and charged as a percent of assets transacted. Usually, they are lower than front-end fees, averaging approximately 1%. Contingent deferred back-end fees, on the other hand, 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 reclassification.
Redemption fees differ from back-end sales loads since they are associated with the fund’s annual operating expenses. Moreover, redemption fees are typically only in effect for a short period—most fund companies use a time frame of 30 days.
Mutual fund investing can carry numerous fees throughout the investment duration, and it's important that investors understand all of them before buying and selling to protect their potential returns. Other fees involved may include sales loads, 12b-1 fees, and account service fees.