Sometimes referred to as a back-end load, exit fee, or contingent-deferred sales charge, the redemption fee is a charge or fee that is assessed when the investor chooses to engage in what is known as mutual fund timing. The reason for the fee is that the process of this strategy can have a detrimental impact on the long-term investors of the fund. In an attempt to discourage the practice of investing in the fund for a short period of time before selling the interest and moving on to another investment opportunity, the redemption fee is usually significant and makes the prospect of using a quick in-quick out approach less attractive.
Depending on the structure of the mutual fund, the redemption fee may be invoked if the investor chooses to hold the investment for less than thirty days. In other cases, the period that the investor must hold onto the shares is longer, with one year being one of the more common time periods associated with the fee. There are situations where the investor must hold onto the shares for longer periods, such as three or five years, in order to avoid paying a redemption fee when the shares are placed back on the market.
The strategy of mutual fund timing, while legal, is not generally met with approval by fund administrators. The reason for this dim view of the strategy is that by buying mutual fund shares then promptly selling them in order to turn a small profit, the fund incurs a greater number of transaction costs. The increase in transaction costs generated by the more frequent purchase and sale activity in turn affects the returns that long-term investors receive from the investment. By imposing a redemption fee, new investors are more likely to purchase the mutual fund shares as a long-term investment, rather than a short-term means of generating returns.
While not all mutual funds are set up in a manner that allows a redemption fee to be assessed, this type of exit fee is fairly common with funds that are based in many countries around the world. For this reason, investors should look closely at the terms that govern the initial purchase of the mutual fund shares, and determine if redemption fees do apply. If there are provisions for charging a redemption fee, the investor should determine how long the shares must be held in order to avoid the fee. It is also important to project the movement of the share prices during that time, and decide if the return would be worth incurring the penalty or even acquiring the shares in the first place.