A Study of The Effects of Redemption Fees On Mutual Fund Performance

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University o f Nevada. Reno College o f Business
A Study of the Effects of Redemption Fees on Mutual Fund Performance
A thesis submitted in partial fulfillm ent o f the requirements for the degree o f Master o f
Science in Economics
by
Jeannine E. Perrault
Dr. Thomas Cargill Thesis A dvisor
D r. Sheri Faircloth C om m ittee M em ber
D r. Elliott Parker Com m ittee M em ber
December. 2002
UMI Number: 1411386
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Copyright t' 2002 Jeannine E. Perrault
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UNIVERSITY
OF NEVADA THE GRADUATE SCHOOL
RENO
We recommend that the thesis

prepared under our supervision by
JEANNINE E. PERRAULT
entitled
A STUDY OF THE EFFECTS OF REDEMPTION FEES

ON MUTUAL FUND PERFORMANCE
be accepted in partial fu lfillm e n t o f the

requirements for the degree o f
MASTER OF SCIENCE
Thomas C a rgill, PhJJ> rfA d viso r
o /k tv < T & l. uc le t!-~

Sheri Faircloth, Ph. D ., Com m ittee Member
E llio tt Parker, Ph. D . , A t-Large Member
Marsha H. Read, Ph. D., Associate Dean, Graduate School
December, 2002
December, 2002
Abstract
A Study of the Effects of Redemption Fees on Mutual Fund
Performance
by
Jeannine E. Perrault
Day trading and short-term investing have been increasingly popular strategies in the
marketplace even among mutual funds. Applying a redemption fee to funds can persuade
investors to strategize for the long-term, thereby reducing fund flow s and creating
stability in the fund so the manager can focus on performance. By reducing cash flows, it
is possible that redemption fees add value to funds.
This paper examines how redemption fees affect excess fund returns and risk. When
considering the entire sample, several results indicate that funds w ith redemption fees
result in greater calendar and annualized returns and higher risk adjusted returns
compared to their peers. However, when looking at the entire sample as well as the
specific categories o f large value and growth, small value and growth, technology,
healthcare, telecommunications, micro, and pacific, there was insufficient evidence to
conclude that redemption fees affected excess returns as well as risk-adjusted returns.
Table of Contents
I. INTRODUCTION 1
II. THE EQUITY MUTUAL FUND INDUSTRY___________ 11
III. LITERATURE REVIEW _________ 20
IV. SUMMARY OF THE DATA 41
V. METHODOLOGY__________________________________ 52
VI. RESULTS__________________________________________________________________ 61
T he E ffects of R e d e m p t io n F e e s on M u t u a l F u n d P e r f o r m a n c e ___________________________ 61
Total sample re s u lts _________________________________________________________________________________________ 61
Large cap growth re s u lts __________________________________________________________________________________ 63
Large eap value results __________________________________________________________________________________ 65
Sm all eap grow th r e s u lts __________________________________________________________________________________ 6~
Sm all cap value results ______________________________________________________________________________________ 69
Healthcare Biotechnology r e s u lts ______________________________________________________________________ “ /
Technology' re s u lts _________________________________________________________________________________________ ~3

Communication results ______________________________________________________________________________________ ~4
M ic ro eap re s u lts ______________________________________________________________________________________________~6
P acific results _________________________________________________________________________________________________
THE EFFECTS OF REDEMPTION FEES ON EXPENSE RATIOS_________________________________________ 79
VII. INTERPRETATIONS AND CONCLUSIONS_______________________________________ 82
C o n s id e r a t io n s ________________________________________________________________________________ 8 6
E x t e n s io n s t o t h is p a p e r ______________________________________________________________________ 8 8
C o n c l u s io n s ___________________________________________________________________________________9 0
VIII. REFERENCES________________________________________ 94
Table of Figures
F ig u r e 1: A v e r a g e 4 0 1 (k.) S a v in g s by A g e ___________________________________________ 2
F ig u r e 2: A v e r a g e r e d e m p t i o n fee a n d e x p ir a t io n p e r io d o v e r t i m e _____________ 7
F ig u r e 3: T o t a u F u n d and E q u it y O n u y A ssets 1 97 0-20 01 ________________________ 13
F ig u r e 4: G r o w t h R a t e of T o t a l N e t A ssets and Eq u i t y N et A s s e t s ___________ 14
F ig u r e 5: C o m p o n e n t s of M utual F u n d G r o w t h 1 9 9 0 -2 0 0 0 ______________________ 15
F ig u r e 6: N et N ew C ash F l o w ' b y I n v e s t m e n t S t y l e 1 9 9 8 -2 0 0 1 ___________________ 16
F ig u r e 7: T o t a l M utual F u n d s 1970-2001 ________________________________________ 17
F ig u r e 8: E q u i t y F u n d A l l o c a t io n b y St y le _______________________________________ 18
F ig u r e 9: R e d e m p t io n s by S t y l e 1 9 9 8 -2 0 0 1 ________________________________________ 19
F ig u r e 10: F u n d s by S t y l e ___________________________________________________________ 41
F ig u r e 11: S a m p l e S t y l e 1 9 9 2 - 2 0 0 1 _________________________________________________ 4 2
F ig u r e 12: R e d e m p t io n F e e s by St y le ______________________________________________ 4 3
F ig u r e 13: R e d e m p t io n F e e P e r c e n t a g e by St y le __________________________________ 4 5
F ig u r e 14: A verage R e d e m p t io n F ee by St y le ______________________________________4 6
F ig u r e 15: R e d e m p t io n F e e F r e q u e n c y _____________________________________________ 4 7
F ig u r e 16: R e d e m p t io n E x p ir a t io n F r e q u e n c y ____________________________________ 4 8
F ig u r e 17: R e d e m p t io n F e e O n l y vs. R e d e m p t io n F ee and Ba c k -E n d Lo ad 49
with permission of the copyright owner. Further reproduction prohibited without permission.
Table of Tables
T a b l e 1: E n t ir e sam ple versus L ip p e r 1000 benchmark ___________________________ 61

T a b l e 2: L a r g e g r o w th fu n d s versus the L ip p e r l a r g e g r o w t h b e n c h m a r k _____64
T a b l e 3: L a r g e c ap v a l u e fu n d s versus L ip p e r l a r g e c a p v a l u e b e n c h m a r k _____6 6
T a b l e 4: S m a l l c a p g r o w t h f u n d s versus th e L ip p e r s m a ll cap g ro w th
BEN CH M AR K_____________________________________________________________________ 68
T a b l e 5: S m a l l c a p v a l u e fu n d s versus th e L ip p e r sm a ll cap value ben c h m a r k 70
T a b l e 6: H e a l t h c a r e / B io t e c h n o l o g y f u n d s v e r s u s t h e L ip p e r
h e a l t h / b io t e c h n o l o g y b e n c h m a r k ___________________________________________ 72
T a b l e 7: T e c h n o l o g y fu n d s v er su s the L ip p e r s c ie n c e a n d t e c h n o l o g y
b e n c h m a r k _____________________________________________________________________ 74
T a b l e 8: C o m m u n i c a t i o n fu n d s versus th e L ip p e r teleco m b en c h m a r k 75
T a b l e 9: M ic r o c a p f u n d s v e r s u s t h e L ip p e r m i c r o c a p b e n c h m a r k _______________ 76
T a b l e 10: P a c if ic funds ver su s the L ip p e r p a c if ic r e g io n b e n c h m a r k ___________ 78

T a b l e 11: R e d e m p t io n f e e e f f e c t s o n e x p e n s e r a t io s 79
A Study o f th e Effects of Redem ption Fees on
Mutual Fund Performance
I. Introduction
Mutual funds have received increased attention in financial literature as overall assets in
the mutual fund industry have increased. Mutual fund growth can be partially attributed
to legislation perm itting tax-deferred savings options along w ith population awareness to
the needs o f investing money. Legislation allow ing 401 (k) and IR A 's (individual
retirement accounts) has had an enormous influence on the growth o f mutual funds
(Poterba et al. 1992). Coupling the growth due to savings options is an awareness to
invest and an increase in marketing efforts by the mutual fund industry. In fact,
marketing may possibly play a bigger role than performance in terms o f influencing
investors. Dellva and Olson (1998) point out that in 1975. mutual funds accounted for a
mere 2 percent o f total financial wealth, but by 1992. they accounted for 11.4 percent.
Laderman and Sm ith (1993) report that mutual fund assets were less than $50 billion in
1977 and rose to $1.6 trillio n by early 1993 and rose to $5.5 trillio n in 1998.
Approximately $600 b illio n was invested between 1990 and 1993 alone. They also
reported that from 1980 to 1992. the percentage o f stocks held by individuals was
reduced from 71 percent to 49.7 percent, whereas the percentage invested in mutual funds
increased from 5 percent to over 35 percent. The Investment Company Institute (2001)
reports that as o f December 2000. 87.9 m illio n individuals owned mutual funds.
Additionally, more than three quarters o f all households owning mutual funds participate
in an employer-sponsored defined contribution plan. Furthermore, the typical mutual
fund owning household has $25,000 invested in mutual funds, w hich represents nearly a
third o f household financial assets. Seven out o f eight shareholder households
incorporate equity funds in their portfolio. Figure one shows the average savings in
401 (k) plans by age.
Figure I: Average 401(k) Savings by Age
Average 401(k) Savings by Age
60s
50s
30s
20s
S $ 100,000 $200,000 $300,000 $400,000 $500,000 $600,000
Dollars Invtstad
By the time a 401 (k) investor turns thirty, that investor, on average, holds approximately
$100,000 in their retirement plan. By the time the average investor is in his or her fifties
to sixties, they have approxim ately h a lf a m illio n dollars saved away for retirement.
3
Mutual funds are required by law to redeem shares on a daily basis, allow ing mutual
funds to be a very liquid investment. In order to stabilize cash flow s, fund companies
may try to reduce the amount o f liq u id ity demanded by investors. One way to reduce
investment flows is for fund companies to impose a redemption fee. A redemption fee
can easily be perceived as an added expense for the investor. A general definition o f a
redemption fee is a transaction charge to the investor by the management company for
selling the mutual fund before a certain set amount o f time, which usually disappears
after holding the mutual fund for a specified length o f time (the Securities Exchange
Commission or SEC has not yet established a legal time period). O nly shareholders who
hold the mutual fund for less than the set period o f time must reimburse the mutual fund
via the fee. Applying a redemption fee can persuade investors to not exit the mutual
fund, thereby reducing flows. By reducing cash flow s, it is possible that redemption fees
add value to mutual funds.
In 1982. the SEC decided to allow mutual funds to inflict a contingent deferred sales
charge upon the sale o f a fund. These sales charges are contingent since they are only-
paid when an investor sells shares o f a fund before a set time defined by the mutual fund
company.
Some clarification as to the definition o f redemption fees is needed before we continue.
Redemption fees are commonly, but incorrectly, categorized as deferred loads (i.e.. back
end loads). Although industry term inology may refer to these fees as "loads."
4
redemption fees should not be considered another term for a "load.” Redemption fees are
sim ilar to deferred loads in terms o f encouraging long-term investment. Deferred sales
loads (back-end loads) are sales commissions usually paid to a broker once the fund is
sold while redemption fees go back to the fund directly. Redemption fees can be
associated with funds that call themselves no-load. As the name implies, no-load mutual
funds do not charge any type o f sales load, yet other fees can be tied to the mutual fund,
and the mutual fund can still be considered no-load. For example, a no-load mutual fund
is allowed to charge redemption fees, purchase fees, exchange fees, etcetera, none o f
which is considered to be a sales load. In addition, a mutual fund is permitted to charge
annual operating expenses and still call itse lf no-load, unless the combined amount o f the
mutual fund's 12 b -1 fees or separate shareholder service fees exceeds 0.25 percent o f the
fund's average annual assets. The SEC has lim ited the 12 b -1 fee to one percent annually
w ith a maximum o f 0.25 percent going to brokers. The sample for this paper had a
weighted average 12b-1 fee o f 77 basis points.
For clarification. 12 b -1 fees are defined as costs being used to cover
advertising/marketing and distribution expenses. In 1980. the mutual fund industry’ got
approval for 12 b -1 fees from the SEC by arguing that these fees would increase fund
sizes, thereby leading to economies o f scale. Flow ever, it appears that 12b-l fees have
contributed to an increase in management expenses (Ferris and Chance 1987). Kihn
(1996) finds that investors are not w illing to pay higher annual 12b-l fees even i f the past
and expected future returns are high. Kihn also reports that his data strongly suggests
that deferred charges are a complement to 12 b -1 fees and a substitute for front-end loads.
Specifically, a mutual fund that imposes a deferred charge, on average, increases its 12b-
1 fees by 51 basis points. Although it w ill not be considered in this analysis, it is
interesting to note that older mutual funds have lower 12 b -1 fees and higher front-end
loads. This may be due to older mutual funds being more established and find it less
d iffic u lt to charge front-end loads compared to newer mutual funds. Some o f the
determinants o f front-end loads reported by Kihn are: whether the mutual fund imposes
deferred marketing charges, whether annual marketing charges (such as 12b-1) can be
charged, whether lower in itia l purchases are allowed, expected returns, past returns, and
the age o f the mutual fund. Some o f these determinants may reflect upon redemption
fees as well.
The SEC (2000) defines a redemption fee as “ another type o f fee that some funds charge
their shareholders when the shareholders redeem their shares. Although a redemption fee
is deducted from redemption proceeds ju st like a deferred sales load, it is not considered
to be a sales load. U nlike a sales load, which is generally used to pay brokers, a
redemption fee is typically used to defray fund costs associated with a shareholder's
redemption and is paid directly back to the fund, not to a broker. The SEC generally
lim its redemption fees to 2 percent (200 basis points)." The Investment Company
Institute defines redemption fees as "another type o f back-end charge when an investor
redeems shares. Unlike contingent deferred sales charges, this fee is paid to the fund. It
covers costs, other than sales costs, involved with redemption. The fee is expressed as a
dollar amount or as a percentage o f the redemption price."
6
The SEC has not yet created a defined time period for redemption fees to "expire."
Ninety days is reported as the most widespread time period fo r redemption fees when
considering all asset classes, and twelve months is reported as being quite common as
well. We w ill show later that twelve months was the most com m on period for expiration
in our sample. W hile historically most mutual funds elim inate the charge after a year,
some mutual funds are now holding out longer. W hitney D o w from Financial Research
Corporation (1999) notes that there have been significant changes in the lengthening o f
fee schedules. A t the end o f 1999. redemption fees averaged a 7.5 month schedule,
whereas in March o f 2001. the average time was up to 9.4 months (see figure two).
Vanguard's PRIM ECAP fund imposes a redemption fee o f 100 basis points, which does
not terminate until after five years. In fact. Vanguard has six mutual funds imposing the
five-year restriction, but has nine mutual funds w ith ju s t a one-year restriction.
INVESCO has opted to employ a fee schedule where the redem ption fee falls with time
and in this case redemptions after 90 days impose a 200 basis point charge and 90-180
days after purchase impose a 100 basis point charge. This type o f strategy is designed to
punish market timers.
Due to the latest interest in redemption fees, one would expect to see the industry average
redemption fee approach the SEC imposed ceiling o f 200 basis points (Dow noted that
200 basis points is a number that has been challenged as being too low) i f mutual fund
companies are truly concerned about market timers. Yet. D o w notes that the fee level for
redemption fees is remaining constant at approximately 100 basis points, while the
7
assessment period is getting longer. This paper w ill verify these statements later w ith the
sample used to conduct this analysis.
Dow also reported that the number o f mutual funds that charge redemption fees has
increased from 322 at year-end 1999. to 585 in the first quarter o f 2001. That is an 82
percent increase in a 15-month period. Lastly. Dow found that the average redemption
fee carried a charge o f 113 basis points at March 2001. while the average was 111 basis
points at year end 1999. showing the fee is holding fairly steady, as mentioned previously
(see figure two).
Figure 2: Average redemption fee and expiration period over time
Vvcragc Redemption Lee Provisions

1 in
S —
II
IQOI
: ( h.K-V I cru:t.;i ; m ifd s
Source: Financial Research Corporation (Whitney Dow)
Long-term investors should be interested in how a redemption fee can add value to their
investments. The redemption fee is frequently attached to a mutual fund in order to
8
so lid ify the cash flows in and out o f a mutual fund, thereby allow ing the mutual fund to
be more return as well as more tax efficient. Short-term investors (market timers)
looking to quickly get a great return and then get out o f the fund, w ill be charged this fee.
which in turn goes back into the mutual fund and the shareholders. Short-term investors
can spoil the performance o f a mutual fund. These investors not only sell to get a quick
profit, but do not sit well during poor performing market times. Also, redemptions
requested during an economic dow nfall w ill force managers to sell portfolio instruments
to increase liquidity rather than being allowed to attempt to ride out the downturn,
creating losses and. in turn, punishing the long-term investors.
Because o f the extra charge for an early exit, the short-term investor may think twice
before buying into the mutual fund in the first place. Likewise, when a shareholder has
invested in the mutual fund, he may think twice before exiting before the stated time
period to avoid that charge, forcing the shareholder to wait out the bumps in the market.
Since the redemption fee charge is invested back into the mutual fund, shareholders are
effectively reimbursed for the trading costs and. to some extent, they are reimbursed for
the losses and the taxes associated w ith short-term investor behavior.
The redemption fee can somewhat shield the long-term investor along w ith the mutual
fund company from the market timer. Not only does the redemption fee diminish cash
flows from fund timers, thereby allow ing the manager to invest in appropriate
instruments rather than holding short-term, low yielding instruments to handle the flows.
9
but also protects investors from the long- and short-term capital gains that they w ill have
to cover fo r the short timers.
As mentioned above, mutual funds w ith several market timers invested in the fund must
adjust accordingly by holding more cash. The downfall to holding cash is accepting a
lower return. Liquid investments do not have the return potential o f other less liquid
offerings. Chordia (1996) found that cash (and cash equivalents) held by mutual funds
increase w ith uncertainty about investor redemptions. Consequently, mutual funds w ith
high levels o f flow s have increased uncertainty and therefore increased levels o f liquidity
(short-term) investments.
This paper examines i f redemption fees have an effect on open-end mutual fund
performance. Several time periods w ill be used to determine i f redemption fees affect
performance positively or negatively. The null and alternative hypotheses tested are
stated below.
H„: Redemption fees do not affect mutual fund performance
Ha: Redemption fees do affect mutual fund performance
It is anticipated that redemption fees w ill positively affect mutual fund performance.
However, it is not expected that large cap mutual funds w ill have a positive effect on
performance, as these funds tend to be long-term investments naturally because o f their
predictability and stability. Therefore, there w ill be no added benefit to holding
10
redemption fee funds when observing the large cap category, as cash flow s are less
volatile. Due to the higher lev els o f cash flows associated w ith the specific sectors along
w ith the pacific category, it is anticipated that these types o f funds w ill be most positively
affected by redemption fees, while the other categories w ill be m arginally affected, with
the exception o f large cap mutual funds which, as mentioned, are not anticipated to be
affected at all. When considering the results o f the effects o f redemption fees on mutual
funds in the entire universe o f funds, redemption fees are not anticipated to have results
showing a consistent benefit due to the large impact from large cap styles, since a
m ajority o f the mutual funds in the entire sample are categorized as large cap growth or
value.
II. The Equity Mutual Fund Industry
The Investment Company Institute (2001) reports that United States households along
w ith businesses continued to use mutual funds for planning and investing in 2001. In
fact, when considering equity, bond, hybrid and money market funds, asset inflow s were
a record $505 billion in 2001 compared to $389 b illio n in 2000 and the previous record o f
$477 billion in 1998. This offsets the decreases in market valuation leaving total assets
for 2001 above seven trillio n fo r the second straight year. In fact, all four categories
experience asset inflow s in 2001 fo r the first time in three years. Money market funds
experienced record inflows, bond and hybrids had positive inflow s for the first tim e since
1998 and equity flows, w hile o f f from highs from previous years, were still positive.
Equity mutual funds continued to be an important investment vehicle for long-term
planning in 2001 as equity funds consisted o f 49 percent o f the overall fund industry
assets. However, because o f the poor economic and market conditions, including the
terrorist attacks on September 11lh. equity mutual funds experienced a decrease in assets
from $3,962 trillio n to $3,418 trillio n for the twelve month period. Net new cash flo w
was still positive for 2001. but fell from $309 b illio n in 2000 to $277 billion in 2001.
The increase in overall assets managed by mutual funds was expected to lead to a
decrease in fees for the investor. Whereas the academic w orld raises concerns about the
trade-off between costs o f m utual funds versus benefits to investors, industry studies
attempt to show the costs are declining due to the extraordinary growth in mutual fund
assets. Researchers at the Investment Company Institute (1998. 1999) analyze data from
1980 to 1997 and use estimated holding periods and redemptions to show that sales-
weighted average expense ratios for the 100 largest stock mutual funds declined from
0.70 percent to 0.56 percent. Cooley o f M om ingstar (1999) studies a smaller and more
homogeneous sample o f mutual funds over the same period and concludes that only no-
load mutual fund expense ratios declined, from 0.80 to 0.73 percent. Figure three shows
the net asset growth for the mutual fund industry as a whole and equity funds separated
and figure four shows the year-over-vear growth rate for the mutual fund industry as a
whole and equity funds separated.
Figures three and four show that in spite o f the poor market and economic conditions in
2001. mutual fund investors as a whole did not withdraw their assets from the market.
Flows into equity mutual funds were o f f from the highs o f previous years, which can be
seen in figure four, but investors did not redeem equity fund shares, on a net basis, fo r the
year. The month o f September had the highest net outflow s ($29,692 m illio n ) fo r the
entire year for equity funds driven by the terrorist attacks which occurred that month.
This was somewhat offset by the month o f November when investors returned $15,152
m illio n to market investments once the risk o f further attacks subsided.
13
Figure 3: Total Fund and Equity Only Assets 1970-2001

Source investment Com pany institute
Total Fund Assets 1970-2001
7,500,000 ------------ ------------------------------------------------------- ---------
7,000.000
6,500,000
6,000,000
5,500,000
5,000,000
4,500,000
0 4,000.000
1 3,500,000
3.000,000
2,500,000
2,000,000
1.500,000
1,000,000
500,000
Total N«t Asstts — Equity Net Assets
Assets o f United States based mutual funds grew at an annual rate o f 19.5 percent from
1990 to 2000 (data through 2001 was not yet available at the tim e o f this w riting). This
growth has caused mutual funds to be the largest financial interm ediary in the United
States. Growth o f assets comes from three sources: new ly reporting funds, performance,
and net new cash flow . The growth o f the three items is charted in figure five.
Almost h a lf o f the asset growth during the time period from 1990 to 2000 (2001 data is
not yet available) was due to performance, which incorporates asset appreciation and
reinvested dividends and capital gain distributions. Net new cash flow s represented 46
percent and the remaining growth was due to new mutual funds.
14
Figure 4: Growth Rate o f Total Net Assets and Equity Net Assets
S ou rce investment Company
YOY Asset Growth 1970-2001
100%
OSS
<0%
85%
80%
75%
70%
85%
50%
55%
50%
45%
40%
g 35%
O 30%
= 25%
S 20%
S 15%
10%
5%
0% ■
- 15%
•20%
•25%
-30%
•35%
•40%
•45%
-50%
“ ““ Total NX Assets " Equity N ft Asstta
Figure six shows that most o f the equity fund categories experienced negative net new
cash flow for 2001. O nly aggressive growth (defined by Investment Company Institute
as mutual funds that invest prim arily in common stocks o f small, growth companies).
growth (defined as those mutual funds that invest prim arily in common stocks o f well-
established companies), growth and income (defined as mutual funds that invest
prim arily in equity securities o f companies w ith a consistent record o f dividend payments
as w ell as seeking capital appreciation), and income (defined as those funds that prim arily
invest in companies w ith a consistent record o f dividend payments and these mutual
funds seek income more than capital appreciation) boasted positive net new cash flow for
the year, whereas the sector (defined as funds that invest prim arily in companies in
related fields) and the four foreign equity categories had negative net new cash flow.
15
When just considering equity funds, net new cash flow (defined by the Investment
Company Institute as the dollar value o f new sales minus redemptions, combined w ith net
exchanges) reached a record $309 b illio n in 2000. or 64 percent more than in 1999.
However. 2001 reached just $32 billion in net new cash flow, which is a year-over-year
decrease o f 90 percent from 2000.
Figure 5: Components of M utual Fund Growth 1990-2000
Components of Mutual Fund Growth: 1990-2000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Tim *
Source investment Com pany institute

■ Net New Cash Flow □ Performance ■N ew ly Reporting Funds
As o f December 2000. aggressive growth represented 31 percent o f net new cash flows
and growth was not far behind at 28 percent. In 2001. these mutual funds s till had
positive new cash flows, but they decreased year over year by 85 percent and 95 percent
16
respectively. Sector mutual funds were the third highest o f the styles in terms o f net new
cash flows for 2000. but had net negative flows in 2001 probably associated to their risk.
The growth and income and income equity categories faired better in 2001 compared to
2000 probably due to their lower risk investment objective.
Figure 6: Net New Cash Flow by Investment Style 1998-2001

Source Investm ent Com pany institute
Nat Naw Cash Flow by Invastmant Styla: 1998-2001

350.000 -
300,000
250,000
•50,000
SAqgraaaJva Growth iGrourth 9 Saetor World Equtty-Emqaring Marfcats

IWortd EquityGlobal lorhf Equity-international EWorld Equity-Jtoqional 3Growth and Incoma
Btncoma Equity Total
Total mutual funds grew from 3 6 1 mutual funds in 1970 to 8.307 mutual funds in 2001.
When singling out equity mutual funds. 294 funds were reported in existence in 1978.
which grew to 4,717 funds in 2001. The total number o f funds and total equity funds by-
year is shown in figure seven.
17
Figure 7: Total Mutual Funds 1970-2001
ToUl Fund* 1970-2001
10.000 ---------------------------------------------------------------------------------------------------------
9,000 ;
8,000
7,000
6,000
6,000
4,000
3,000
2,000
1,000
? ^ j •s? f f j j
* * T o U l Fu n d s 1 Number o f Equity Fund*
Source investm ent C om pany institute
The chart reveals that equity funds represent a majority o f all mutual funds. The
remaining classes represent hybrid, bond, and money market funds. When considering
all mutual fund types, the number o f mutual funds grew by 152 in 2001. which was the
smallest increase since 1981.
As o f December 2001. mutual fund assets for the various equity categories are broken out
in figure eight. Overall, growth mutual funds and growth and income mutual funds held
the most assets in 2001 (31 percent), when considering just equity mutual funds.
18
Figure 8: Equity Fund Allocation by Style

Source investment C om pany institute
Equity Fund Allocation by Style
Income Equity
4% Aggressive Growth
Growth and Income 17%
31%
A
Growth
31%
World Equity-Global
World Equity-Regional 5% Sector
1% 5%
World Equity-Emerging
World Equity- Markets
International 0%
6%
As mentioned, equity mutual funds saw net new inflows in 2 0 0 1. and they also saw a
year-over-year decrease in fund redemptions. Redemptions represent investor-driven
cash outflows from a mutual fund. Redemptions fell to $893 b illio n from $1.03 trillion
the year before. Redemptions by style are shown in figure nine.
The style w ith the highest redemptions is growth, which again, is the largest style (tied
with growth and income) in terms o f equity assets by class. The growth style appears to
have a steady grow th rate for redemptions through 2000 and then decreases in 2001.
Growth and income is the second highest in terms o f redemptions for the period from
1998 to 2000 and is also the largest in total asset size. However, redemptions for the
19
growth and income category decreased in 2001 from the previous year as investors
searched for a more stable investment. This reduces the redemptions to sim ilar levels as
aggressive growth and w orld equity international. W hile most styles appear to have
growth in redemptions year over year, w orld equity regional (defined by Investment
Company Institute as equity funds w hich invest in companies based in a specific part o f
the world, such as pacific funds), income equity and world equity emerging markets
(defined as funds which invest prim arily in companies based in developing regions o f the
w orld) appear to be relatively fiat. Again, increases in redemptions from investors
attribute to unstable cash flows preventing money managers from effectively buying and
selling equities in their portfolios.
Figure 9: Redemptions by Style 1998-2001

Source investment Company institute
Redemption* by Style: 1998-2001

400,000
350.000
300.000
250.000
200.000
150.000
100.000
50,000
-50,000
1998 1999 2000 2001
■Aggntalva Grown “ Growth "Sector

World EquKy^mgaring M orton ■World Equlty£lobal "W orld Equtty-Jntemationel
World EquKWIagional “ Growth and Incomo "Income Equity
20
III. Literature Review
Dellva and Olson (1998) report that fees may be warranted i f they permit the mutual fund
company to lower other expenses or improve performance. They wanted to determine i f
there is any fundamental difference in the various categories o f fees w ith respect to
expense ratios and mutual fund performance. The results show that on average, mutual
funds with lower expense ratios have superior performance. They also found that, on
average. 12 b -1 fees, deferred sales charges, and redemption fees increase expenses in
total whereas mutual funds w ith front-end loads generally have lower expenses.
Although they found the inclusion o f redemption fees increase expenses, they also
discovered that, on average, mutual funds with redemption fees, along w ith 12 b -1 fees
earn higher risk adjusted returns but mutual funds with front-end load charges earn lo w e r
risk adjusted returns.
They also found that funds consistently having top performance do not incur more costs
than other funds to better utilize information. Moreover, they found that funds w ith
superior performance actually had lower expenses. When considering just these results,
the investor should seek mutual funds w ith lower total expenses as additional fees are not
providing any economic benefit.
Dellva and Olson found that redemption fees, specifically, add positive return to overall
performance. They report that fo r a given expense ratio, mutual funds w ith redemption
fees, on average, supply investors w ith a higher risk adjusted return. Therefore, they state
21
that the existence o f some redemption fees attached to funds can be justified to investors.
I f two mutual funds have the same expense ratio, then the fund w ith the redemption fee
w ill most lik e ly have a higher risk adjusted performance when compared to the mutual
fund without the redemption fee. They find that in three measures o f risk adjusted
performance, mutual funds w ith redemption fees have superior performance. Therefore,
they state redemption fees may be warranted.
This paper builds on the work o f Dellva and Olson: however, the papers are different in
two ways. First, instead o f looking at ju st 568 mutual funds which meet a broad set o f
criteria: this paper w ill look at specific fund categories. Second, their sample only looked
at the time period o f 1987 to 1992. or 24 quarterly observations. This paper w ill look at
several more one-year time periods (one year return periods ending December from 1992
to 2001). along w ith a three-, five-, and ten-year annualized time period.
Nanda. Narayanan and Warther (2000) looked at the effects o f loads in terms o f liq u id ity
and manager ability. The authors find that funds which constrain withdrawals may have
to charge lower fees and provide higher returns when investors w ith low liq u id ity needs
are scarce. They also report that liq u id ity costs can be significant for mutual funds.
Increased liq u id ity needs are the result o f investors placing a higher value on current
income rather than future income, which in turn causes the mutual fund to be prepared to
support the liq u id ity needs, despite the extra costs o f liquidity. However, mutual funds
can be structured to reduce liq u id ity needs by adding loads and redemption fees. This
reduces the risk o f having to sell securities quickly to meet liq u id ity as w ell as reducing
the opportunity costs o f holding cash equivalent assets in anticipation o f redemptions.
However, i f costs o f managing liq u id ity shocks fall and/or there is a decrease in the
uncertainty o f the liq u id ity needs o f investors, there w ill be a lower proportion o f mutual
funds charging loads. The authors report that their analysis suggests that the large
increase in no-load mutual funds compared to mutual funds w ith loads in recent years is
due to a decrease in costs for sustaining liquidity as financial markets have become more
efficient.
The article reports that mutual funds which experience large liq u id ity strains from their
investors results in poorer performance for the mutual fund. As mentioned, poor
performance is due to portfolio managers having to sell securities and increase cash
holdings or simply hold cash in anticipation o f withdrawals. Therefore, the manager has
incentive to attract those investors w ith low liquidity needs. The manager can do this by
instilling back-end loads or redemption fees, thereby discouraging those investors with
high liquidity needs. The paper notes that i f investors with low liquidity needs are rare,
then the manager must draw them into the fund w ith other incentives, such as low
management fees, thereby generating higher net returns. Since low liq u id ity investors
are fairly scarce, managers need to choose a combination o f exit penalties and
management fees, w h ile generating an appealing return that w ill attract these low
liquidity investors.
The paper goes on to show that a low er liq u id ity cost is adversely related to managers'
return. Put another way. a manager's expected profit w ill be higher i f the fund can
attract lower liq uidity investors. It was found that funds targeting experienced investors
having low liq uidity needs received the highest expected return. The mutual fund group
receiving the lowest return was that o f those investors lacking experience and having
high liquidity needs.
Nanda. Narayanan and Warther found that as high liq u id ity investor vo latility increases,
mutual funds without loads, which are held by high liquidity investors, become less
profitable, and therefore managers start introducing loaded mutual funds. In order for
managers to avoid the increased liquidity costs o f high liquidity investors. load fund
managers are w illin g to offe r a higher rate o f return to attract low liquidity investors.
They go on to report that liq u id ity shocks in flic t greater burden on managers w ith greater
ability. In turn, they conclude that lower a b ility managers provide the no-load mutual
funds as they tend to be the providers o f liquidity.
They then go on to examine the level o f the exit fee that would discourage the higher
liquidity investors from investing in the fund. In theory, to discourage these investors,
the fee must be at the appropriate level so their expected rate o f return from investing in a
fund with an exit fee is less than the expected rate o f return from investing in another
fund.
Although this paper generates an interesting discussion, it does not discuss redemption
fees specifically. It merely blends all back-end charges into what the authors call exit
fees. Nor does this paper focus on direct mutual fund categories as this paper w ill do.
24
The paper does inform us that the m utual funds generating the highest returns are those
which target experienced investors having low liquidity needs. Creating exiting penalties
can reduce cash flows out o f a fund by targeting investors who have less preference for
liquidity.
Edelen (1999) finds that open-end mutual funds provide a way to diversify while not
having to take the fu ll direct burden o f costs to cover liquidity. W hile performance is
usually seen as the variable to determine a manager's ability to identify w rongly priced
securities, fund cash flows can easily skew returns, changing the appearance o f a
manager's ability. However, managers must provide liquidity to their investors, in turn
causing management to depend not o n ly on a manager's ability to choose securities but
also the investors* decisions to move in and out o f the fund. When considering the
trading done to facilitate liquidity needs, many writings have shown that liq u id ity has an
adverse effect on mutual fund performance. In fact, depending on tim ing, a fund's
average risk-adjusted return could be negative even though the manager is managing
information at the highest level o f efficiency.
Edelen's study analyzes how mutual fund managers' information-processing efficiency
and liquidity trading affect performance. He reports that trades made in a portfolio due to
liquidity needs dim inish the performance o f the mutual fund, regardless o f the direction
o f the trade. Therefore, expected m utual fund performance must consider the ability for
managers to analyze inform ation, w h ile also looking at the cash flows o f the fund.
An important contribution that Edelen makes is his finding that liquidity shocks move
managers away from their optim al portfolio. Managers have a target portfolio they create
through research to m inim ize risk and maximize returns. Creating an optim al portfolio
calls for certain percentages o f the mutual fund to be allocated to specific stocks and
sectors. Flows in and out o f the fund require the portfolio to be re-allocated. I f the flow
is big enough, the manager may have to sell or buy a certain percentage o f all stocks in
the portfolio to keep that target allocation. This could lead to expensive transaction costs.
An alternative would be to have the manager hold a high allocation o f cash. Yet. holding
cash is not the best alternative because i f investors wanted to invest in cash, they would
buy a money market mutual fund, coupled by the fact that managers need to beat their
benchmarks to achieve their fu ll compensation. Therefore. Edelen proposed that a
mutual fund's performance w ill depend on two terms, a term that reflects managers
trading based on how well a manager processes inform ation (this is expected to be a
positive term) and a term that reflects the mutual fund's cash flows (this is expected to be
a negative term).
Edelen reports that the average open-end mutual fund experiences a considerable volume
o f inflow s and outflows over a year's time. In fact, he reports that one-half o f the
average fund's assets are redeemed in a year and over two-thirds o f the average fund's
assets entered the fund as new in flo w from the prior year. In the average one-year time
period, a fund sees 33 percent o f the dollars invested in the fund enter and leave w ithin
one year. Obviously, a typical fund has to deal with a significant volume o f in flow s and
outflows for any given year.
26
Although it is not discussed in his paper, it would be interesting to see the effects that
redemption fees have on mutual fund Hows. One would expect to see a decrease, at least
in outflows, for these funds because o f the redemption fee.
Edelen also reported that the average annual volume o f liq u id ity purchases and sales are
both over 100 percent o f assets managed. Analysis indicated that a material fraction o f
overall trading activity is believably motivated by investors' need for liquidity. In fact, it
was reported that flow volume is equivalent to almost h a lf o f the trading volume at the
median mutual fund. After conducting the analysis. Edelen discovered that
approximately 28 percent o f total trading done in a mutual fund is liq u id ity motivated.
Also reported was that cash turnover (defined as cash which enters and leaves the mutual
fund w ithin six months), brings w ith it annual turnover o f 15 percent o f total assets
managed. This leads to the conclusion that trading due to cash flows is not due to net
growth or decline o f assets managed, but rather. liquidity trading. In fact, he also reports
that liquidity trading is material for stable-sized mutual funds as well.
In order to handle cash flows, most managers have some sort o f cash allocation minimum
from zero to ten percent. Any more than ten percent w ill catch the eyes o f consultants and
other critics. Holding cash allows liq u id ity shocks to be met w ithout trading securities
and having to re-allocate the portfolio. Therefore, most managers probably accumulate
cash in preparation for liquidity needs. Edelen points out that i f the accumulation period
is short, then the overall volume o f purchase and sale a ctivity w ill approach the total
27
in flo w and outflow. However, i f the accumulation period is long, then in flo w s w ill be
offset by outflows (and vice versa) and the overall volume o f liquidity-driven purchases
and sales w ill be a mere fraction o f total in flo w and outflow . The findings suggest that
approximately 30 percent o f all flows never show up as an incremental trade, but rather
cross with a flow in the opposite direction, or the How is included in voluntary trades
which would have occurred regardless.
Edelen reports that on average. 75 percent o f all cash inflow s in a six-month period end
up as final purchases. The remaining 25 percent o f inflow s are carried across six-m onth
periods. This reinforces the notion that managers keep some sort o f cash reserve or
accumulation to handle flows.
Edelen analyzes returns in the absence o f liquidity demands, or when net flow s are equal
to zero. The typical performance o f a fund after deducting fees and expenses is zero
when considering the liquidity-trading effect. Put another way. the typical mutual fund
manager produces a return that is almost equivalent to the expenses that are charged to
the fund.
Although it was expected that the coefficient for the manager's ability to use inform ation
was going to be positive, it was found to be insignificantly different from zero. Edelen
points out several possibilities for this result. First, managers simply may not be using
their information to the fullest ability. Put another way. markets may be too efficient for
managers to beat as all inform ation has been considered when pricing securities. Second.
28
trading is not always done based o f f o f information, but for tax purposes, o r to re-allocate
the portfolio. Third, managers react to information differently. W h ile one manager may
be able to identify effective, useful inform ation, other managers may choose to trade
using less effective information. This is all related to manager preferences and
paradigms. Lastly, several studies have discussed that fund performance is sensitive to
the benchmark in comparison. Edelen points out that manager underperformance has
little to do with a manager's ability to run the fund, but rather the underperformance is
the cause from the liquidity service which mutual fund managers provide to investors.
The typical benchmark does not consider the liquidity service which mutual fund
managers provide. In order for a benchmark to be appropriate, the benchmark must
consider the costs o f providing liq u id ity to investors.
Although Edelen's paper does not directly look at how redemption fees affect mutual
fund Hows, the assumption for our purposes is that redemption fees decrease the net
Hows in mutual funds, thereby a llo w in g the mutual fund manager to focus on the
investment strategy rather then focusing on having enough cash to handle the Hows,
thereby leading to better performance. Reducing fund Hows prev ents the portfolio from
needing to be re-allocated, thereby reducing the potential for capital losses, as well as
transaction costs.
Fant (1999) also looks at fund flow s, but from an investor's behavior perspective. Fant
investigates the behavior by looking at the interaction o f investor's demand for equity
securities with stock returns. He looked at four flows: new sales, redemptions.
exchanges-in. and exchanges-out. He found no relationship between returns and new
sales or redemptions. However, he did find that returns are positively related to
concurrent exchanges-in. and negatively related to exchanges-out. Therefore, the inverse
relationship between aggregate fund flows and returns exists only between returns and
exchanges-out. This poses another question in regard to redemption fees: do all mutual
fund companies uphold the charge i f the redemption is from one family mutual fund to
the same fam ily mutual fund? In many cases, the fee may be waived. This w ould be a
consideration when analyzing the effects that redemption fees have on mutual fund cash
Hows.
Fant verifies for this paper, as other authors have, that cash Hows can affect fund
performance. In his study, exchanges-out was the only flo w to negatively affect mutual
fund performance.
Sirri and Tufano (1998) looked at aggressive growth, growth and income, and long-term
growth equity funds to fin d the causes for cash (lows in and out o f a fund. Their sample
included 690 funds offered by 288 mutual fund families. They looked at how
performance, fees. risk, marketing, available inform ation, media spotlight, and a couple
other variables affected the flows in and out o f a fund. This paper takes a different
perspective in terms o f cash flows. Whereas the other papers reported the effects on
performance due to a change in cash flows, this paper looks at how cash flows change
due to performance.
30
When considering performance, they found that mutual funds that performed the worst
had a positive but m inor relationship between returns and fund flows. In other words,
mutual funds that performed very badly were not greatly punished by investors in terms
o f investors leaving the fund. These results are quite suiprising. Not so surprising is the
fact that funds that had stellar performance also experienced a positive performance flow.
In fact, the performance-flow relationship that they found was very strong for mutual
funds that had historical performance w orthy o f being in the top 20th percentile o f the
prior year. In summary, there is a strong performance sensitivity relationship among the
higher performers and a weak relationship among the funds that are the poorest
performers.
Although this is a significant outcome, a positive linear relationship between asset growth
and fund performance has already been documented. What is more interesting is the
effects that fees have on mutual funds. A fter noting the effects on flow s due to
performance, we can note that, in general, i f a fund outperforms, that fund gains assets
and fee revenue rises, but i f returns are low . this leads to loss o f assets, and therefore fee
revenue is more modest.
The writers report that mutual funds w ith higher fees tend to grow more slo w ly in assets
than funds w ith lower fees. They go on to see i f flows are affected when mutual funds
change their fee structures. As the authors predicted, they found that flows are inversely
related to fee changes. They report that mutual funds that increase total fees by one
standard deviation from the mean (from 1.74 percent to 2.41 percent), have flow s drop
31
from the mean o f 11.4 percent per year to 3.0 percent. When looking at the effects o f a
fee increase versus a fee decrease, they find that fee increases are not associated w ith
mutual fund outflows: however, decreases in fees are associated with mutual fund
inflows. Therefore, as fees are lowered, the flows into the fund increase, when holding
the return constant. They report for a 20 basis point decrease in fees, flows would
increase by 4.2 percent.
The authors go on to report the effects o f fund loads. Changes in expenses are inversely
related to flows, but not changes in loads. Increasing loads leads to an increase in total
fees, which in itia lly makes the fund less attractive to investors, but it does so by
increasing marketing effo rt and thereby decreasing search costs, probably because the
higher load motivates sales brokers to sell these funds more aggressive so they collect the
load commission. Therefore, it appears that the two effects cancel each other out. so the
changes in loads do not increase or decrease flows. Their results do show, however, that
decreasing loads may reduce flow s since the incentive for brokers to sell the reduced-load
fund dissipate.
When factoring in performance w ith a loaded mutual fund, meager performers do not get
punished with cash outflow s. A n explanation for cash flow s not being negatively
impacted is that investors may be reluctant to remove dollars from their load mutual fund
even i f the performance is lacking since they had to pay the up-front costs to enter the
mutual fund, or may be charged the back-end load for e xiting the mutual fund.
On the other hand, changes in expense ratios are less related to fund m arketing efforts
because these fees cover management fees, administration costs, and other costs. I f these
costs are increased, fund in flo w w ill lower. In fact, it is the reduction in expense ratios
that is most strongly related to fund flow s, w ith reductions in annual fees having a strong
positive relationship on fund inflows.
In summary. they discovered that shareholders o f equity mutual funds tend to purchase
stellar-performing mutual funds w hile they hold on to their poor perform ing funds.
Flows are fee-sensitive, but consumers' response to expenses is also asymmetric in that
they respond differently to high and lo w fees, as well as to expense increases and
decreases.
Lettau's (1996) analysis o f mutual fund flows concluded that mutual fund investors
transform their portfolio allocation after exam ining market outcomes. In fact, for riskier
mutual funds, the correlation between flow s into mutual funds and returns is positive and
quite sizeable. His analysis shows that ju s t returns alone can explain up to 54 percent o f
mutual fund flows.
From the previous literature discussions, it seems that investors could learn which funds
to invest in from watching the behavior o f other investors. Gruber (1996) found evidence
that the pattern o f consumer investing behavior is rational. He finds that i f investors
invest in mutual funds receiving inflow s and to pull out o f funds which are experiencing
outflows, the investors w ould earn a risk-adjusted return which beats passive index funds,
even after fees.
Carhart (1997) reported the results o f his research in 1992 which showed that mutual
fund persistence in expense ratios drives much o f the long-term persistence in the fund
performance.
Carhart showed that expenses have at least a one-for-one negative impact on mutual fund
performance and that turnover also negatively impacts mutual fund performance. He
estimated that portfolio trading reduces performance by approximately 0.95 percent o f
the trade's market value. Also, he found that fund performance and load fees are strongly
negatively correlated (a discovery which has been shown in previous work), and thought
it was most likely due to higher total transaction costs for load funds. When holding
expense ratios constant and ignoring the load fees, load funds under perform no-load
funds by approximately 80 basis points a year.
Mutual fund managers often claim that expenses and turnover do not reduce performance
since investors are paying for the quality o f the manager's information and because
managers trade only to increase expected returns net o f transaction costs. Theretore.
expenses and turnover should not have a direct negative effect on performance, but rather
a neutral or positive effect.
34
Carhart's results indicate a strong relationship between performance and expense ratios,
turnover, and load fees. The results show that the relationship between performance and
expense ratios and turnover suggest that, on average, funds do not recoup their
investment costs through higher returns. In terms o f turnover, the results suggest that for
every 100-basis-point increase in turnover, annual return drops by approximately 95 basis
points per every buy and sell transaction. This means there are transaction costs o f 95
basis points per every buy and sell transaction.
Carhart's research agrees w ith previous conclusions in that he identifies that load fees are
significantly negatively related to performance. A fte r removing the worst-performing
quintile o f funds, the average load fund underperforms the average no-load fund by
approximately 80 basis points per year. His results contradict the marketing claim that
funds with loads have managers which are more skilled. He does note that the
underperformance o f load mutual funds is probably at least partially explained by higher
total transaction costs, since load mutual funds tend to have higher turnover than no-load
funds.
Carhart has an important contribution to this paper since his information is useful when
discussing redemption fees as redemption fees are assumed to reduce transaction costs.
Carhart discovered that expense ratios, transaction costs, and load fees all have a direct,
negative impact on mutual fund performance. Transaction outlays are reduced w ith
mutual funds with redemption fees because there are fewer inflows and outflows from the
mutual fund, thereby reducing transactions needed to raise (use) cash or re-allocate the
mutual fund portfolio. This paper w ill look at mutual fund expense ratios as well.
However, this paper w ill be looking at the effect that redemption fees have on expense
ratios whereas Carhart looked at how expense ratios affected performance.
Although the redemption fee is not a load, it is interesting to q u ic k ly discuss some more
o f the results which loads have had on performance. Hooks (1996) examined 1.012
mutual funds to analyze the relationship that sales loads and expenses had on returns.
Unlike other reports, his paper looks at not only the effects o f sales loads on returns, but
also incorporates the annual expenses. He concluded that no-load mutual funds are not
necessarily better then loaded funds. He found the mutual funds that have low expenses
and low (or even high) loads outperformed the average expense, no-load mutual funds.
Another finding was when load funds are held over a 15-year period, the performance
was adequate enough to warrant the sales load.
Pettengil et al. (1993) reported that mutual funds with loads s lig h tly outperformed no
load funds. They accredited this to load funds often having lo w er annual expenses and
therefore the funds have higher returns, net o f expenses. They discovered that an investor
who holds their funds for eleven years would benefit from buying a loaded fund. Since
loaded funds tend to have lower annual expenses, these mutual funds tend to outperform
those funds w ith higher annual expenses w ith no loads. This is referred to as the annual
fee hypothesis. Obviously, mutual funds w ith loads target the low' liq u id ity, long-term
investor as the investor, on average, must hold the loaded fund fo r at least eleven years to
benefit from the load.
36
It is also important to discuss the concept o f market efficiency. Ippolito (1989) notes that
informed traders beat the market before expenses but make no excess returns after netting
out the expense o f gathering information. Therefore, in equilibrium, there is not an
incentive to have a preference for either a passive index mutual fund or an actively
managed mutual fund. I f mutual funds represent uninformed investors, then the returns,
adjusted for risk and expenses, w ill be lower than returns that are available among a
passive index mutual fund.
Ippolito results showed that mutual funds are efficient. The coefficients for turnover,
management fee. and expense ratio variables are insignificantly different from zero or
funds with higher turnover, fees, and expenses earn risk-adjusted returns which are
sufficient to offset the higher charges. He also reported that his data suggests that load
funds earn rates o f return which possibly offset the load charge. This is consistent w ith
his findings that an 850-basis-point sales charge w ould be offset after a holding period o f
five to six years. Again, mutual funds with sales charges are more suited for the long
term. low-liquid investor.
M alkiel (1995) challenged previous literature in regard to mutual fund performance
persistence. Previous literature has pointed out predictable patterns in the time series o f
security returns. Earlier literature also has shown that mutual fund returns sometimes
provide investors w ith an opportunity to earn stellar risk-adjusted (excess) returns and
therefore money managers can outperform the market (before management expenses).
37
He challenged previous findings in performance consistency due to survivorship bias. He
reported that many mutual fund companies w ill elim inate the poor performing funds by
m olding them into one o f their more successful mutual funds, thereby erasing the poor
perform ing mutual fund from existence. In the end. the best performing and well
marketed mutual funds continue to exist. Because o f this, only the better performing
mutual funds remain in existence, therefore overstating the accomplishments o f mutual
fund management. In order to imitate the poor perform ing funds. Malkiel included in
his analysis all mutual funds in existence during a certain time period, whether they
survived in the long run or not.
M alkiel found his estimates to be true. A fte r conducting the analysis, he found that the
return for all mutual funds during 1982 to 1994 returned 15.69 percent, while funds still
in existence in 1994 returned 17.09 percent. The S&P 500 Index had a return o f 17.52
percent. This reveals that mutual funds s till in existence came close to meeting the index,
w hile all mutual funds, including those that were dropped o r merged into another mutual
fund grossly underperformed the index. He also found that even the gross returns o f all
mutual funds in existence each year returned a mere 16.70 percent, which again is less
than the S&P 500 return o f 17.52 percent. This tells us that there were enough
transaction costs acquired by the mutual funds and/or enough poorly performing non-
S&P stocks in the mutual fund portfolios to make their gross returns less than that o f the
market index. In summary. M alkiel found that excluding nonsurviving funds in
38
performance consistency analysis greatly overstates the returns earned by mutual fund
investors.
M alkiel then analyzed his sample to see i f mutual fund managers generate enough in
returns to make up for fees imposed on the funds. He discovered that surviving mutual
funds do not produce excess returns for investors after expenses, yet the funds earn
enough in excess gross returns to cover fund expenses. He also reported that mutual fund
investors do not get their money’s worth from the expenditures acquired in the
management o f mutual funds, even when expenditure data is lim ited to funds spent for
investment advice.
M alkiel went on to analyze the hot hand (known as winning follow ed by winning)
phenomenon, meaning he tried to find evidence that mutual funds w h ich achieve above-
average returns can continue the trend o f better performance. He suggests that historical
findings suggesting that hot hand phenomenon exists were due to survivorship bias. He
reports that there was considerable persistence in funds in the 1970s. Hot hands occur
more often than a w in follow ed by a loss. In fact, the null hypothesis o f winning
persistence w as rejected in all but two o f the years that he analyzed. The results show the
existence o f cold hand (losing followed by losing) phenomenon as w e ll. O ver the entire
period studied, winners were inclined to repeat almost tw o-thirds o f the time.
Persistence was therefore quite strong for mutual funds in the 1970s and fo r at least some
years in the 1980s through 1986. Still, although positive results were found. M alkiel
pointed out two cautions. First, the results found were not robust, meaning that he found
39
strong persistence in the 1970s. but persistence failed to exist in performance during the
1980s. Secondly, the persistence results are likely influenced by survivorship bias. To
accurately account for persistence, a sample o f funds which existed in both the base and
follow ing periods needs to be analyzed.
The paper moves on to analyze the persistence in performance o f those mutual funds that
make the Forbes honor roll. In the first eight years o f their experiment, the honor ro ll
funds outperformed the S&P 500 Index. However, over the last eight years o f their
experiment, the Forbes honor roll funds did much worse than the index. When
considering the entire 16-year period, the honor roll funds underperformed the S&P 500
Stock Index.
He then analyzed the relationship between expense ratios and fund performance. He
found a strong and significant negative relationship between a fund's total expense ratios
and its net performance. He also found some evidence that spending money on
investment advice does increase net performance, but the coefficient was not statistically
significant. This paper w ill also look at mutual fund expense ratios. However, as
mentioned, this paper w ill analyze the effects that redemption fees have on expense
ratios.
In summary. M alkiel concluded that there is no reason to throw out the b elie f that
security markets are extremely efficient. He states that most investors would be better o f f
purchasing index (passive) mutual funds, as they are lo w in expenses, rather than
40
utilizing a "hot handed" fund manager. He points out that active management usually
fails to provide excess returns and tends to generate greater tax burdens to investors,
whereas passive management (index funds) has a lesser burden due to its lower turnover.
41
IV. Summary of the Data
The data provided by Lipper contains 2.579 open-ended mutual funds. O f these funds.
245 or 9.5 percent have redemption fees as o f December 2001. O f the total 2.579 funds,
the breakout by sector is in figure ten.
Figure 10: Funds by Style
Funds by Style
Communications
Technology Large Cap Growth
2%
15% 32%
Small Cap Value
11%^-"-
Smalf Cap Growth

16%
Micro Cap Large Cap Valuo
1% Pacific 13%
3%
From the pie chart above, you can see that the large cap growth style dominated the
sample at 32 percent. Small cap growth mutual funds, technology mutual funds, large
cap value mutual funds, and small cap value mutual funds were all very close, ow ning 11
to 16 percent o f the total sample o f mutual funds. M icro cap was the smallest sample o f
the group at 15 mutual funds or 1 percent o f all mutual funds. Micro cap clearly does not
42
meet the 30 mutual fund sample size minimum, but w ill be analyzed, to some extent,
regardless o f the low sample size.
Let us now consider the sector breakout with regard to time. The style allocation for the
time period from 1992 to 2001 is broken out in figure eleven.
Figure I I : Sample Style 1992-2001
Sample Style: 1992:2001
2000 2001
□ Health I Large Cap Growth □ Large Cap Value ■ Pacific □ Micro Cap
■ Small Cap Growth RSmall Cap Value □ Technology ■ Communications
Although for the most part, there has been a lot o f consistency year after year, technology
mutual funds have increased the most in the various categories from five percent in
December 1992 to fifteen percent o f all mutual funds in December o f 2001. Large cap
43
value has seen a decrease in the percentage o f funds from 21 percent in 1992 to 13
percent in 2001.
As mentioned, there were 245 funds in the original sample containing redemption fees.
The breakout o f these 245 funds by style is in figure twelve.
Figure 12: Redemption Fees by Style
Redemption Fees by Style
Technology
34%
Small Cap Value Communications

13% ^ 3%
Large Cap Growth

Small Cap Growth 13%
13% Pacific
3%
O f the 245 mutual funds w ith redemption fees, the technology style has the greatest
percentage at 34 percent. This is no surprise as this style is very risky and is known to
have short timers invest in these types o f mutual funds. Risk is defined for this paper as
the chance that the value or return on investment w ill be different than its expected value.
44
Put another way. it is the chance of an undesirable financial event.
Healthcare/biotechnology mutual funds come in second with 14 percent o f the total
sample o f 245 funds. This is another risky sector, so it is not a surprise to see such a
large percentage o f mutual funds with redemption fees in this class. Large cap growth,
small cap growth and small cap value mutual funds all have 13 percent o f the total
sample including redemption fees. Communications, pacific funds, and micro cap funds
all have a very low percentage o f the total sample. This is surprising as these sectors are
very risky and may interest short-term investors although their sample sizes as a whole
are much smaller. In fact, the low percentage for the communications and micro cap
sectors is due to their o rig in a lly small sample size.
Pacific mutual funds (defined by Investment Company Institute as funds that concentrate
their investments in equity securities w ith prim ary trading markets or operations
concentrated in the western pacific basin region or a single country w ithin that region)
may not include redemption fees because investors are hesitant to enter the pacific market
to begin with due to its constant troubles. Because o f this, managers may be focusing on
the scarce investors and resist applying a redemption fee in order to prevent investors
from going elsewhere.
Redemption fees are more popular in certain sectors than in others. Figure thirteen shows
the percentage o f funds by style with redemption fees, which provides a clearer picture o f
what styles favor redemption fees.
45
Figure 13: Redemption Fee Percentage by Style
Redemption Fee Percentage by Style
Styf*
■ No Redemption □ Redemption
Technology has the second most mutual funds w ith redemption fees at 21.4 percent.
Healthcare/biotechnology mutual funds are third w ith 19.1 percent o f the sample having
redemption fees. Large growth and large value both have very few mutual funds w ith
redemption fees in their sample at just 3.8 percent. The remaining categories have the
following percentage o f mutual funds with redemption fees in this sample: pacific has
11.0 percent, communications has 12.7 percent, small cap growth has 7.6 percent, and
small cap value has 10.8 percent.
46
To understand the impact o f what is being charged to the short-time investors, the
average redemption fee by class is graphed in figure fourteen.
Figure 14: Average Redemption Fee by Style
Average Redemption Fee by Style
Communications
Technology
Small Cap Value
Small Cap Growth
Micro Cap 1J0%'
Pacific
Large Cap Value
Large Cap Growth
Health
0 .00% 0.20% 0.40% 0.80% 1.0 0 % 1 .2 0 % 1.40% 1.60% t.80%
Redemption Fee
Although the m icro cap style does not have many m utual funds in the sample, on
average, the m icro cap style has the highest redemption fee at an average o f 1.80 percent,
which is extremely close to the two percent maximum set by the Securities Exchange
Commission. Technology and small cap value mutual funds are the second highest at
1.37 percent. Understandably, large cap growth and large cap value mutual funds have
the lowest average fees in the group at 1.09 and 1.10 percent respectively. This is not
47
surprising as these groups tend to be less risky and therefore attract the long-term
investor.
The average redemption fee as o f December 2001 for the whole sample o f funds
containing redemption fees was 1.29 percent and the average length until the redemption
fee terminated was 8.17 months. The frequencies o f redemption fees can be found in
figure fifteen.
Figure 15: Redemption Fee Frequency
Redemption Fee Frequency
2000
1500
Frequency
1000
500
0
0.00% 0.50% 0.75% 1.00% 1.50% 1.75% 2.00%
O Frequency 2334 1 19 147 5 1 72
Redem ption Fee
It is clear from this chart that most o f the funds in the sample do not have redemption fees
as o f December 2001. O f those funds that have the redemption fee. the most popular fee
is at one percent w ith 147 mutual funds or 5.7 percent o f all mutual funds, or 60 percent
48
o f the mutual funds w ith redemption fees charging a fee o f one percent. The second most
charged fee is double that at two percent, w ith 72 mutual funds charging that fee. As
mentioned, two percent is the maximum that can be charged as a redemption fee as
defined by the Securities Exchange Commission. It is again interesting to note that
although two percent is the maximum which investment companies can charge, most
companies choose to charge ju st one percent.
It is also interesting to observe the length fo r the redemption fees to expire. The
frequencies for length o f tim e in months until redemption fee expiration are charted in
figure sixteen.
Figure 16: Redemption Expiration Frequency
Redemption Expiration Frequency
2500
2000
1500
>
u
e
3
cr
u.
1000
500
G Frequency 2354 28 52 34 27 57 7 33 4 1 2
M onths
49
In our sample, the most popular expiration date for redemption fees was twelve months,
or one year. In fact. 57 o f the 245 (23 percent) mutual funds w ith redemption fees used
an expiration o f one year. Several mutual funds anticipated that two months would be
enough to push away short-time investors as this expiration time was the second most
popular w ith 52 mutual funds applying two months as their expiration. O nly tw o mutual
funds, both in the Vanguard fa m ily o f funds, had an expiration o f 60 months or five
years.
Figure 17: Redemption Fee Only vs. Redemption Fee and Back-End Load
Redemption Only versus Both
100%
Styla
■ Just Redemption □B oth Redemption and Back End Load
O f the entire sample o f 245 mutual funds w ith redemption fees. 51 o f these mutual funds
(21 percent) had both a redemption fee and a back-end load and were therefore excluded
50
from the analysis. This leaves us w ith 191 mutual funds w ith redemption fees only. The
breakdown o f the 51 mutual funds w ith both redemption fees and back-end loads by style
is charted in figure seventeen.
The chart reveals that communication and pacific mutual funds have mutual funds w ith
redemption fees only rather than having both a redemption fee and a back-end load. The
micro cap style has 40 percent o f the mutual funds w ith both a redemption fee and a
back-end load: again, this sample size is small to begin w ith at ju st fifteen mutual funds.
Both healthcare mutual funds and technology mutual funds have 26 percent o f the mutual
funds with redemption fees and back-end loads whereas the remaining 74 percent o f
mutual funds w ith redemption fees are redemption fee only.
O f the remaining 191 mutual funds w ith redemption fees, six funds did not exist for an
entire year ending December 2001. and were therefore also dropped from the analysis as
one year was needed to make the initial sample. This leaves us w ith a total o f 185 mutual
funds with redemption fees. The mutual funds without redemption fees needed at least
twelve months o f returns as w ell: otherwise they were also dropped. We started w ith
2.334 mutual funds without redemption fees. O f that total. 170 funds were dropped as
they were not in existence for at least one year. leaving a total o f 2.164 mutual funds
without redemption fees. Therefore, when considering the remaining sample, we have
7.9 percent o f all the mutual funds containing just redemption fees.
51
An interesting observance is that several mutual fund families had redemption fees
attached to every mutual fund that made the sample. A mutual fund fam ily represents an
investment management company offering a number o f different mutual funds. These
families that applied a redemption fee to every- mutual fund were Wasatch Funds. Charles
Schwab. Royce Funds. Firsthand Funds, and Amerindian Funds. F idelity had 51 mutual
funds in the sample, and 47 o f these 51 mutual funds or 92 percent had redemption fees
attached.
52
V. Methodology
The data for this research w ill consist o f a time series o f gross m onthly returns for the
follow ing categories o f open-end equity funds: large cap growth, large cap value, pacific
funds, technology funds, communication funds, healthcare/biotechnology funds, micro
cap. small cap value, and small cap growth. Along w ith these fund categories, the entire
universe (consisting o f all the various equity classes) w ill undergo the experimentation
first, and the analysis o f the specific categories w ill follow . Gross returns are being used
to strip other variables that could affect the analysis such as front- and back- end loads. In
terms o f measures, all funds w ill have at least a twelve-month history and the return data
series is complete, meaning there are no values missing in the time series, therefore
freeing the sample o f survivor bias. A ll funds in the study w ill still be in existence as o f
December. 2001. The mutual funds with both back-end loads and redemption fees w ill
not be considered due to confusion as to which fee would influence the investor to not
invest into the fund. Therefore, to purely look at the effects o f redemption fees rather
than back-end loads, mutual funds which utilize both fees w ill be excluded.
Pacific, technology, healthcare/biotechnology, communication, m icro cap and small cap
mutual funds w ill be observed due to the higher level o f risk associated w ith these
categories. These categories are more likely to benefit from redemption fees due to
higher volatility and investment perspectives tending to be shorter than other categories.
Again, it is not expected that large cap mutual funds w ith redemption fees w ill out
perform mutual funds w ithout redemption fees. Since most investors choose large cap
53
mutual funds for the long term, these mutual funds are typically less volatile, cash flows
are naturally more stable and therefore, redemption fees should not benefit a mutual
fund's return.
Dow (1999) noted that funds which earn redemption fees are more likely to represent
illiq u id sector categories. They ranked categories by percentage o f funds having a
redemption fee and found that categories such as technology and communications were at
the top o f list at 47 percent and 45 percent o f funds respectively having redemption fees
in their category. with four other sector categories placing among the top ten. As shown
from the previous chapter, this analysis had 21 percent o f technology funds charging
redemption fees, and only 13 percent in the communications sector charging redemption
fees. Healthcare funds in our case had more funds w ith redemption fees than
communications with 19 percent o f the style charging the fee. D ow also reported that
right behind these sectors were region-specific categories including Pacific/Asia ex-Japan
(43 percent) and Japan Stock (32 percent). It was noted that short-term investors target
these categories o f funds because the time difference between the closing o f domestic
markets and overseas markets allows for significant profit potential.
D i Teresa o f Momingstar (1998) also noted that sector and regional funds often carry
redemption fees because short-term investors tend to buy sector- and market-specific
categories. Since these types o f m utual funds tend to have fewer assets than more
diversified mutual funds, market tim ers can be particularly harm ful, explaining why all o f
F idelity's and Vanguard's sector funds charge redemption fees. Other fund companies
54
are following, such as Putnam as they are adding the fee to their emerging markets and
Asia Pacific funds.
The time series to be analyzed are the three-, five-, and ten-annual return periods along
w ith the one-year calendar returns from 1991 to 2001. In addition, to see how funds with
redemption fees perform when considering risk, the three-year Sharpe ratio w ill be
observed. Because o f the varying time periods, sample sizes w ill change. Final sample
sizes are provided in the results section o f this paper. A sample must contain at least 30
funds to warrant a regression for this analysis.
The mutual funds w ill be chosen from U pper's database o f mutual funds as o f December
2001 (as o f December 2001. there were a total o f 13.772 funds). Each fund w ill have a
m ajority o f the fund invested in equity securities. From the total open-ended mutual fund
database, mutual funds w ill be classified as technology equity, healthcare/biotechnology
equity, communication equity, pacific equity, large cap growth, large cap value, micro
cap. small cap grow th, and small cap value based o f f o f Upper's categories. The total
number o f mutual funds represented for each category is presented in the results section
o f this paper.
Lipper (2001) defines micro cap mutual funds as funds that invest prim arily in funds with
market capitalizations less than $300 m illio n at the time o f purchase. Pacific region
funds are defined as funds that concentrate their investments in equity securities with
primary trading markets or operations concentrated in the western pacific basin region or
a single country- w ith in that region. Small cap funds are defined as those funds that invest
prim arily in companies w ith market capitalizations o f less than $1 b illion at the time o f
purchase. Large cap funds were not distinctly defined, but considering m id cap funds
were defined as anything less than $5 billion, it can be assumed that large cap funds are
defined as those funds which invest prim arily in companies w ith market capitalizations o f
greater than $5 b illio n at the tim e o f purchase.
Growth funds are defined by Lipper as mutual funds which invest in companies with
long-term earnings expected to grow significantly faster than the earnings o f the stocks
represented in the major unmanaged stock indices. Value funds are defined as mutual
funds that combine a growth o f earnings orientation and an income requirement for level
and/or rising dividends.
In regard to the sector funds, the health and biotechnology funds are defined as mutual
funds that invest 65 percent o f their equity portfolios in shares o f companies engaged in
healthcare, medicine, and biotechnology. Science and technology funds are defined as
those investing 65 percent o f their equity portfolio in science and technology stocks.
Telecommunication funds invest at least 65 percent o f their assets in the equity securities
o f domestic and foreign companies engaged in the development, manufacture, or sale o f
telecommunications serv ices o r equipment.
Lipper provided the database o f gross returns needed for the research reflecting the time
periods through December 2001. Lipper provided the calendar year returns, therefore.
56
the three-, five-, and ten-year annualized returns needed to be calculated. The returns
were calculated w ith the following basic annual holding period return equation:
Annual HPR = ((Ending Value/Beginning Value)Al/ n ) - l
with n being the number o f years the investment is held and in our case represented three,
five, or ten.
Gross excess returns over the applicable benchmark for each fund w ill be regressed
against whether or not the fund has a redemption fee. Essentially, the redemption fee w ill
be regressed as a dummy variable: w ith zero meaning the fund does not have a
redemption fee and one meaning the fund does have a redemption fee. The end result
w ill be the fo llo w in g linear regression:
Y = a + bX
with Y being the gross excess return in relation to the benchmark, a is the intercept, b is
the redemption fee coefficient, and X is the dum m y variable consisting o f zero or one. A
positive coefficient for the redemption fee w ould insinuate that redemption fees have a
positive effect on mutual fund returns w hile a coefficient o f zero w ould mean there is no
effect on fund returns and a coefficient o f less than zero would illustrate that redemption
fees have a negative effect on mutual fund returns. This w ill also be done for the Sharpe
ratio to see i f redemption fees lead to a better return per unit o f risk. In the above
57
regression formula, the Sharpe ratio would now replace gross excess returns and
represent the variable Y.
A regression analysis w ill then be performed to see i f redemption fees affect mutual
funds in a positive way. Depending on sample size, each category could have up to
fourteen regressions performed to see i f the redemption fee positively or negatively
affects a fund in terms o f performance and risk.
Once regressions are performed, the coefficients w ill be analyzed to see i f they are
positive, since a positive coefficient shows that a redemption fee contributed positively to
the performance o f the m utual fund. Also, the t-statistics w ill be observed to verify that
the coefficients were indeed statistically significant. Broadly speaking, the test o f
significance approach, o r t-statistic. is a procedure by which sample results are used to
verify the truth or falsity o f a null hypothesis. Assuming the degree o f freedom to always
be at least 30 (which is this paper's sample m inim um ), the t-statistic must be ± 2.042 or
greater to be deemed statistically significant at the 95 percent level. Put differently, for
30 degrees o f freedom, the probability o f obtaining a t-statistic o f 2.042 or greater is .05
or five percent.
The final ratio that w ill be analyzed is the three-year Sharpe ratio. Positive coefficients
for the Sharpe ratio show that returns per unit o f risk are higher when the fund has a
redemption fee. The calculation for the Sharpe ratio is as follows:
58
Sharpe's Measure = total portfolio return - risk free rate
portfolio standard deviation
A final regression w ill be done to see the effect redemption fees have on expense ratios.
This regression w ill be done on the entire universe o f funds. Here, the redemption fee
w ill no longer be a dummy variable, but w ill take on the actual fee that it charges for
early redemption. The regression w ill be as follows:
Z = c + dQ
w ith Z being the expense ratio, c being the intercept, d being the redemption coefficient,
and Q being the redemption fee. I f the redemption coefficient is positive, mutual funds
w ith redemption fees w ill tend to have higher expense ratios. I f the coefficient is
negative, mutual funds w ith redemption fees w ill tend to have lower expense ratios.
Since redemption fees are designed to recover the costs o f taxes and trading to the long
term mutual fund investors, w hich are caused by the short-term investor. I do not expect
redemption fees to consistently have an effect on expense ratios. Redemption fees do not
provide any revenue to the mutual fund company or the managers who run the fund and
therefore should not have an effect on expense ratios.
In summary, this paper intends to test i f mutual funds in the categories o f pacific,
technology, communication, healthcare/biotechnology, micro cap. small cap value, and
59
small cap growth w ill be positively affected by redemption fees when comparing mutual
funds among the same categories, with the exception being large cap funds, due to their
long-term investment horizon. The n ull and alternative hypotheses are listed again
below:
H0: Redemption fees do not affect mutual fund performance
Ha: Redemption fees do affect mutual fund performance
Before we proceed, there are several items that must be considered w ith this analysis.
First, we assume that the mutual fund company actually upholds the redemption fee.
Some companies may actually waive the fee i f the investor is transferring among funds
w ithin the same fam ily or i f the investor is in good standing. I f the fee is waived, the
a bility o f the fee to reduce cash flows diminishes.
Second, we must realize that redemption fees are relativity new. The fee itse lf has been
in existence for quite some time, but it is not until recently that managers started fully
utilizing it. Therefore, this analysis should be revisited in a few years once funds have a
history with the fee. Also, because the fee is so new. there still may be some confusion
as to what a redemption fee is exactly. W ith the confusion may come incorrect reporting
from fund families as to whether or not they impose a redemption fee.
60
Lastly, this paper did not include those redem ption fees w ith Hat fee charges, but only
those charging a percentage o f assets. Several funds charge flat fees from $ 10 to S50 for
withdrawing from the mutual fund. Many o f these fees do not disappear in tim e and
represent the costs for w irin g or sending a check.
6!
VI. Results
The Effects of Redemption Fees on Mutual Fund Performance
Total sample results

The first regressions looked at how redemption fees affect performance for the entire
sample, including technology, communications, small cap value, small cap growth, m icro
cap. healthcare/biotechnology. large cap growth, large cap value, and pacific funds. The
excess return was calculated using the Lipper 1000 as the benchmark. Table one shows
the results o f this regression.
Table I: Entire sample versus Lipper 1000 benchmark
Entire Sample vs. Lipper

1000 Benchmark
1.27% 9.04% 4.44% 1.54% -0 18% -4 45% 4.72%
0.572 2 944 3 325 0.764 -0 138 -2 285 1.679
0.022 0.031 0 013 0020 0013 0019 0 028
240 306 416 553 679 870 1143
19 20 29 35 40 53 65
7 92% 6.54% 6.97% 6.33% 5.89% 609% 5.69%
Entire Sample vs. Lipper

1000 Benchmark
23.35% -2.13% -0.22% 6.22% 478% 17 34% 24.07%
4.534 -0.913 -0.144 3.974 3 588 5.867 5.181
0.829 -0.012 0.000 0.016 0.013 0.030 0 046
1393 1740 2345 1393 870 240 1393
84 111 185 84 53 19 84
6.03% 6.38% 7.88% 6.03% 609% 7 92% 6.03%
62
When considering the one-year calendar returns, the t-statistic is significant in 1993.
1994. 1997. and 1999. Three out o f four o f these time periods had positive redemption
fee coefficients, w hile one had a negative coefficient. Some o f these positive coefficients
are quite large and to some extent, unlikely. For example, the coefficient in 1999 was
23.35 percent. Not only was the coefficient quite large in 1999. meaning in this year
redemption fees added a lot o f benefit to mutual fund performance, but the t-statistic is
quite large as w ell at 4.53. Although these results are encouraging in terms o f
redemption fees having a positive effect on mutual fund performance, redemption fees in
1997 appeared to hurt mutual fund performance with a negative coefficient o f 4.45
percent. This was also statistically significant as the t-statistic was negative 2.29.
The annualized returns show sim ilar results to the calendar year returns. A ll regressions
were statistically significant, including the Sharpe ratio, and a ll regressions resulted in
positive coefficients for the redemption fee variable. The three-year return resulted in a
coefficient o f 6.22 percent, the five-year return regression resulted in a coefficient o f 4.78
percent and the ten-year regression reported a coefficient o f 17.34 percent. Even more
surprising is the Sharpe measure result as the coefficient was 24.07 percent. This means
that mutual funds w ith redemption fees, on average for our sample time period, added
24.07 percent to the risk-adjusted return. This seems quite large and not very likely.
This rather large coefficient could be due to the sample and a more accurate analysis may
be looking at how all equity mutual funds perform w ith redemption fees, rather than just
the selected mutual fund classes for this paper. In short, while the three- and five-year
63
annualized results are encouraging, the ten-year and Sharpe ratio coefficient results seem
unlikely.
Large cap grow th results

The large cap growth mutual funds for the v arious time periods were regressed against
the Lipper large cap growth index. As expected, there was a large enough sample from
the first year to warrant a regression. However, in the first year, along w ith the ten-vear
annualized return, only one mutual fund, or one percent o f the total sample size, charged
a redemption fee. This held true for year tw o as w ell as there were 109 funds, yet just
one mutual fund (less than one percent) w ith redemption fees. In 1994. total funds w ith
redemptions increased to two funds. More m utual funds were assigning redem ption fees
toward the end o f the ten-year period. In the first five years, the average percentage o f
large cap growth funds w ith redemption fees was 1.41 percent. The last five years had an
average o f 1.93 percent. The final year (2001) resulted in 3.07 percent o f all mutual
funds in this class charging redemption fees to their short-term shareholders. The results
are reported in table two.
Because so few funds had redemption fees in this style, it is d iffic u lt to gauge the true
effect that redemption fees have on large cap grow th funds. Only one o f the one-year
periods shows significant results, which was 1995. The year o f 1995 resulted in a
positive coefficient o f 11.05 percent. However, we s till must reiterate that even though
this one time period had significant results, it is due to a small amount o f m utual funds
that greatly outperformed the benchmark. We clearly cannot come to any solid
64
conclusions on this style because o f the lack o f funds w ith redemption fees during the
statistically significant time periods. The remaining calendar-year returns do not show
any significant results. This is not surprising as it was expected that redemption fees do
not have any effect on the performance o f large cap growth mutual funds due to the
style's long-term horizon and stability o f cash flows.
Tabic 2: Large growth funds versus the Lipper large grow th benchmark
LCG Funds vs. Lipper
-3.82% -4.15% -5.28% 11 05% -2 31% -1 47% 10.65%

-1 06 -0.586 -1.979 2.824 -0.8G8 -0 405 1 823
0.04 0071 0 027 0 039 0026 0 036 0 058
84 109 148 200 238 295 399
1 1 2 4 4 4 5
1 19% 0.92% 1 35% 2 00% 1 68% 1 36% 1 25%
LCG Funds vs. Lipper
3.27% -1 38% -3.85% -2.10% -1.25% -3.08% -7.21%
-0.86 -0.566 -1 225 -1 265 -0 396 -0457 -1 062
-0.14 0024 0031 0.017 0.031 0.067 0.068
480 606 781 480 295 84 480
8 14 24 8 4 1 8
1 67% 2.31% 3.07% 1 67% 1.36% 1.19% 1.67%
In regard to the annual returns, as w ith the calendar-year returns, very few mutual funds
w ith redemption fees existed in the regressions. The three-year had the highest in
percentage terms, and even it was a mere 1.67 percent. Therefore, it is not surprising that
there were no statistically significant t-statistics in these three regressions. Lastly, the
65
Sharpe measure was also plagued by a low percentage o f mutual funds w ith redemption
fees in the sample (1.67 percent). This regression also failed to be statistically
significant.
Large cap value results

Large cap value provided sim ilar difficulties to that o f the large cap growth style. The
first and second one-year period returns (December o f 1992 and 1993) had no mutual
funds with a redemption fee: therefore, a regression analysis was not generated in those
tw o time periods. The one-year return ending December 1994 finally revealed one
mutual fund with the redemption fee. Unfortunately, we have only one redemption fee
for the one-year periods ending December o f 1994. 1995. 1996. and 1997. We move up
to two funds with redemption fees in period ending December 1998. As w ith the large
cap growth mutual fund analysis, we cannot come to any solid conclusions as to the
influence that redemption fees have on mutual fund performance unless there is a fair
amount o f mutual funds w ith the redemption fee at any given return period. The
regression results are in table three.
The one-year return in 1996 had a positive coefficient o f 9.14 percent w ith a t-statistic
which was statistically significant at 2.44. Since only one fund in the sample had a
redemption fee. the results tell us that this one fund (in this case the Dreyfus large
company value fund) greatly outperformed the market and just happened to have a
redemption fee attached. This same fund greatly underperformed the market in 1997.
causing the coefficient to be negative 11.58 percent. This result was also statistically
66
significant w ith a t-statistic o f negative 2.62. No other one-vear time periods were
statistically significant other than those just mentioned. Therefore, all results that were
significant were due to one mutual fund. We obviously cannot conclude that redemption
fees affect performance in a positive (negative) way due to one fund outperforming
(underperforming).
Tabic 3: Large cap value funds versus Lipper large cap value benchmark
LCV Funds vs. Lipper LCV

Index
NA NA -0 67% 963% 9.14% -11 58% 1 01%
NA NA -0203 1 870 2 441 -2.625 0 193
NA NA 0.033 0 052 0037 0.044 0 052
50 63 83 103 124 150 180
0 0 1 1 1 1 2
0.00% 0.00% 1 20% 0 97% 0.81% 067% 111%
LCV Funds vs. Lipper LCV

Index
6.69% -5.45% -0.59% -1.32% -3.75% NA -7.96%
1.535 -1.455 -0.336 -0.503 -0.825 NA -0.528
0.044 0.037 0.018 0026 0.046 NA 0.151
212 251 307 212 150 NA 212
3 5 11 3 1 NA 3
1 42% 1 99% 3.58% 1.42% 0.67% NA 1 42%
The same holds for the regressions carried out on the annualized returns. The three-year
annualized return and three-year Sharpe ratio had only three mutual funds in the sample
with redemption fees. Worse yet. the five-year annualized return had only one mutual
fund w ith redemption fees. The ten-year regression was not performed at all as there
67
were no mutual funds w ith redemption fees w ith ten years worth o f data. Because o f the
lack o f redemption fees, it is not surprising that all the t-statistics for the annualized
returns are not statistically significant.
Like large cap growth, this style sim ply did not have enough mutual funds with
redemption fees. Although starting in 1998. there appears to be an upward trend in terms
o f percentage o f funds in this style having redemption fees, there were still only
approximately four percent o f funds having redemption fees in the large cap value style
as o f December 2001. The last four time periods had at least one percent o f the total style
having redemption fees and had more than one fund w ith redemption fees. These periods
did not show redemption fees having any effects, positive or negative, on the
performance o f the mutual funds, as all the t-statistics were insignificant and we can
conclude that redemption fees do not affect the performance o f large value m utual funds.
These results were expected in this style and therefore are not surprising. L ike large cap
growih. this style is a long-term investment and therefore, cash Hows are more stable,
elim inating the need for redemption fees.
Small cap growth results

Although the small growth sample size was large enough in the first year to carry out a
regression analysis, this first year included only two mutual funds, or five percent o f the
total sample size w ith redemption fees. Every one-year time period had a relative ly small
percentage o f mutual funds o f the total sample style charging redemption fees. The
68
benchmark for the regressions was the Lipper small cap growth index and the results are
in table four.
Table 4: Small cap growth funds versus the Lipper small cap growth benchmark
SCG Funds vs. Lipper

SCG Index
-7 07% -1 37% 4.05% 1 09% 1 50% 2 89% -3.73%
-1 22 -0.308 1.181 0 226 0.382 0 796 -1.212
006 0.045 0034 0.048 0039 0036 0.031
38 47 66 95 128 179 227
2 3 5 7 8 9 12
5.26% 6.38% 7 58% 7 37% 6 25% 503% 5.29%
SCG Funds vs. Lipper

SCG Index
4 72% 5 36% 9 96% 266% 308% 27 09% 11 35%
-1.09 1 477 3.643 06 95 0868 5007 1 407
-04 9 0 036 0027 0 038 0035 0.054 0 081
271 325 382 271 179 38 271
15 18 24 15 9 2 15
5 54% 5.54% 6 28% 5 54% 5 03% 5.26% 5.54%
The only statistically significant result for the calendar year returns was in December
2001. This time period had 24 funds, or 6.28 percent o f funds with redemption fees.
This one-year period had a positive coefficient o f 9.96 percent and a t-statistic o f 3.64.
meaning that for this time period, the small cap growth mutual funds w hich were
applying redemption fees had. on average, excess returns o f 9.96 percent over the Lipper
small cap growth benchmark.
The ten-vear annualized return was the only time period o f the annualized returns to be
statistically significant. The redemption fee coefficient was positive at 27.09 percent and
69
the t-statistic was 5.01. However, it can be seen from table four that only two mutual
funds with redemption fees existed for this sample. These two mutual funds just
happened to greatly outperform the benchmark during the ten-vear annualized return
analysis. In this case, these mutual funds were the Wasatch Core Growth and the
Wasatch Small Cap Stock funds, which are known across the industry as being strong
performers. Lastly, although the three-vear Sharpe ratio had a very high coefficient, it
was also insignificant.
Small cap value results

Small cap value had a large enough sample size for the full analysis in the first calendar
year. Results are reported in table five.
O nly years 1997 and 2001 are statistically significant for the one year calendar returns.
For the calendar year 1997. redemption fees, on average, underperformed the index by
5.29 percent. The last calendar year. December o f 2001. resulted in a positive coefficient
o f 4.05 percent meaning that funds w ith redemption fees in this period, on average,
outperformed the index by 4.05 percent.
In regard to annualized returns, the three-year and five-year returns are statistically
significant, while the ten year is not. The three-year return had 20 funds w ith redemption
fees in the sample and it resulted in a positive coefficient o f 5.54 percent and was
statistically significant w ith a t-statistic o f 3.04. This means that for our sample, on
70
average, a fund with a redemption fee outperformed the benchmark by 5.54 percent. The
five-year return also resulted in a positive coefficient at 4.58% w ith a t-statistic o f 2.22.
Table 5: Small cap value funds versus the Lipper small cap value benchmark
SCV Funds vs. Lipper SCV

Index
445% 345% 2.64% -0 44% -0.04% -5.29% 2.02%
0.85 0.871 1 186 -0 139 -0.015 -2.088 0.990
0.05 0 040 0 022 0.032 0.024 0025 0 020
31 40 56 70 89 105 158
4 4 6 7 9 11 14
12 90% 10 00% 10 71% 1000% 10 11% 1048% 8 86%
SCV Funds vs. Lipper SCV

Index
4 74% -3.74% 4.05% 5.54% 4.58% 4 17% 15 71%
-0.68 -1 766 2.137 3043 2 223 0 719 2.239
-0 09 0021 0 019 0.018 0 021 0 058 0070
205 235 259 205 105 31 205
20 23 26 20 11 4 20
9.76% 9 79% 10 04% 9 76% 10 48% 12 90% 9.76%
Lastly, the three-year Sharpe ratio had a positive coefficient o f 15.71 percent and was
statistically significant w ith a t-statistic o f 2.40. This means that for this sample and time
period, funds with redemption fees, on average, added 15.71 percent reward per unit o f
risk to their mutual funds. This seems highly unlikely and it w ould be interesting to see a
five- and/or ten-year Sharpe ratio to see i f there is some consistency among the results.
The results for small cap value are clearly mixed. The one-year calendar returns had two
statistically significant coefficients; one negative and one positive. However, the three-
71
and five-year annualized returns, along w ith the three-vear Sharpe ratio had statistically
significant positive coefficients. S till, there is not enough consistency to state that
redemption fees affect mutual fund performance.
Healthcare/Biotechnology results
The healthcare/biotechnology mutual funds for the various time periods were regressed
against the Lipper healthcare/biotechnology index. Table six reports the results for this
category.
Healthcare did not have a large enough sample size to warrant a regression until 1997.
when at that point 33 funds existed in the sample. The sample size steadily increases to
2001. where the mutual funds in existence increase by 85 percent over the year 2000 and
funds w ith redemption fees nearly double. Clearly, healthcare funds are gaining
popularity w ith the investor as more funds are becoming available and the sector is
growing.
The first one-year return (1997) resulted in a positive coefficient o f 7.05 percent:
however, the t-statistic was insignificant at 1.794. The one-year return for 1998 resulted
in an even higher coefficient and t-statistic at 13.60 percent and 2.213 respectively. This
result means that for this time period and sample, having a redemption fee added, on
average. 13.60% to a mutual fund's excess return.
72
Table 6: Healthcare/Biotechnology funds versus the Lipper health/biotechnology benchmark
Health Funds vs. Lipper
NA NA NA NA NA 7.05% 13.60%
NA NA NA NA NA 1.794 2.213
NA NA NA NA NA .04 06
9 14 17 20 22 33 45
4 4 4 4 4 7 8
44.44% 28.57% 23 53% 20.00% 18 18% 21.21% 17 78%
Health Funds vs. Lipper Health
-3.10% -11.51% -4 14% -5.09% 4.73% NA -2.08%

-0.276 -1 352 -1.840 -1 014 0671 NA -0 177
0.11 0.09 0.02 005 043 NA 0 12
53 75 139 53 33 NA 53
10 10 22 10 7 NA 10
18 87% 13 33% 15 83% 18 87% 21.21% NA 18 87%
The remaining one year returns from 1999 to 2001 all had negative coefficients: in fact,
the year 2000 had a negative coefficient o f 11.51 percent. However, none o f these tests
resulted in t-statistics that were significant.
Lastly, the three- and five-year annualized returns produced statistically insignificant
results. These regressions had approximately 20 percent o f the total sample charging
redemption fees to their short-term shareholders. The Sharpe measure had a negative
coefficient o f 2.08 percent meaning that mutual funds w ith redemption fees, on average,
reduced the Sharpe ratio by 2.08 percent. However, like the three- and five-year
annualized returns, the Sharpe ratio was not statistically significant. The ten-vear
regression was not examined due to the sample size being too small.
73
Technology results
The technology style had the m inimum sample size o f 30 for the period ending December
1995. At this time, six funds, or 20 percent o f all technology funds included in the
sample for this time period had redemption fees. This style was regressed against the
Lipper science and technology index. The results for the technology regressions are in
table seven.
As expected with this style, a large percentage o f the mutual funds offered charge
redemption fees to the short-term investor. In fact, for each time period studied, there
was always at least 15 percent o f the total number o f mutual funds u tilizin g the
redemption fee. Because o f the high percentage o f funds w ith redemption fees, the
technology style gives us the best window look at how redemption fees affect
performance.
The technology regressions showed only two one-year time periods where the t-statistics
were statistically significant. Both o f these time periods resulted in positive coefficients
for the redemption fee variable. These tim e periods were 1996 and 1998 and they had
quite large coefficients o f 12.68 and 21.04 percent respectively. This means that in 1998.
on average, mutual funds w ith redemption fees for this sample outperformed the Lipper
benchmark by 21.04 percent. It was expected that mutual funds charging redemption
fees would benefit in this category. Therefore, these results were not surprising since this
style tends to have a lot o f short-term investors, thereby causing unstable mutual fund
cash flows.
74
Table 7: Technology funds versus the Lipper science and technology benchmark
Technology Funds vs.

Lippe^ciencefTechlD)^^
NA NA NA 6.96% 12.68% -2.00% 21.04%
NA NA NA 1.173 2.464 -0.673 2.525
NA NA NA 0 059 0.051 0.030 0.083
13 14 19 30 35 55 71
5 5 5 6 6 12 14
38.46% 35.71% 26.32% 20 00% 17 14% 21.82% 19 72%
Technology Funds vs.

Lipper Science/Tech IPX
18.86% -4.98% 4.22% 002% 1.92% NA 0 78%
1.129 -1 481 1 946 0.005 0403 NA 0 144
0.167 0034 00 22 0029 0 048 NA 0 054
95 160 344 95 55 NA 95
17 27 60 17 12 NA 17
17 89% 16.88% 17 44% 17 89% 21 82% NA 17 89%
The annualized returns and Sharpe results are not as expected. The redemption tee
coefficients are positive, but they are small and more im portantly, insignificant. The
expectation was to see some o f the strongest results in this entire analysis in these
regressions: however the results do not leave much evidence o f redemption fees having
positive effects on excess performance in relation to the market as well as providing
positive effects in terms o f return per unit o f risk.
Comm unication results

The communications style is still relatively new. In fact, even the index only has two
years worth o f returns. Because o f this, it was not until year ten (December 2001) where
the sample size was at least 30. Since we only had one year w ith the sample size o f at
least 30. no regressions were done for the three-, five-, and ten-year annualized returns as
w ell as the three-year Sharpe ratio. Therefore, for this style, only one regression was
performed and the results are reported in table eight.
The one regression executed had a negative coefficient o f 3.10 percent, but did not have a
statistically significant t-statistic. Because o f this and more importantly, because o f the
lack o f data to conduct analysis, this category is inconclusive and the null hypothesis is
not rejected. From the table, we can report that a sizeable amount o f mutual funds (up to
37.5 percent) in this style have redemption fees. Like the micro cap style, the effects that
redemption fees have on mutual funds w ould be worth revisiting in the future once more
return periods o f data are available.
Table 8: Communication funds versus the Lipper telecom benchmark
Communication Funds vs.

Lipper Telecom IPX
NA NA NA NA NA NA NA
3 4 8 9 11 12 12
1 1 3 3 3 3 3
33.33% 2 5 00 % 37.50% 33.33% 27.27% 25.00% 25.00%
Communication Funds vs.

Lipper Telecom IPX
NA NA -3.10% NA NA NA NA
NA NA -0.587 NA NA NA NA
NA NA 0.053 NA NA NA NA
16 21 49 NA NA NA NA
3 4 7 NA NA NA NA
18.75% 19.05% 14.29% NA NA NA NA
76
Micro cap results

As mentioned earlier, micro cap funds had a very small sample size as o f December.
2001. Even the Lipper index w hich was used as the benchmark, did not experience its
fu ll one-year return until December o f 19%. This style w ill continue to experience
development and growth in the future and would be worth reanalyzing in a few years.
When looking at the mutual funds w ith just redemption fees (excluding those w ith both a
load and redemption fee), only 13 mutual funds had a fu ll year's worth o f data as o f
December. 2001. Regardless, some regressions were performed merely for observation.
The results are in table nine.
Table 9: Micro cap funds versus the Lipper micro cap benchmark
Micro Cap Funds vs.

Lipper MC Index
2 2 3 3 4 8 9
0 0 0 0 1 2 2
0.00% 0.00% 0.00% 0.00% 25 00% 25.00% 22.22%
Micro Cap Funds vs.

Lipper MC Index
22.00% -11 44% 0.79% -5.40% NA NA -9.33%
0.935 -0.365 0.062 -0.112 NA NA -0.108
0.235 0.314 0.127 0.482 NA NA 0 860
12 12 13 12 NA NA 12
3 3 3 3 NA NA 3
25.00% 25.00% 23.08% 25.00% NA NA 25.00%
77
The table shows us that when considering our sample, this style did not have any mutual
funds with redemption fees until 1996. Although the sample size was statistically
insignificant, regressions were performed for the last three years (1999 to 2001). The low
sample size results in the regressions having insignificant t-statistics and fairly large
standard errors.
The results indicate positive coefficients in 1999 and 2001 and a negative coefficient in
2000. The coefficient was quite large in 1999 at 22 percent. Regardless, we cannot
ignore the fact that the regressions are not statistically meaningful. As mentioned, this
style would be interesting to revisit in the future once the sample size is larger.
The three-vear annualized return was also regressed merely fo r observation since the
sample size was too small to meet the m inim um for this paper. The regression resulted in
a negative coefficient. The Sharpe measure was no exception as it too had a small
sample size and insignificant results, but regardless resulted in a negative coefficient o f
9.33 percent.
Pacific results
The pacific style did not have the m inim um sample size o f 30 until 1997 or the sixth year.
A t this time, four o f the funds (13.33 percent) had redemption fees. The results are
reported in table ten.
78
Tabic 10: Pacific funds versus the Lipper pacific region benchmark
Pacific Funds vs. Lipper

Pacific Region IPX
NA NA NA NA NA 12.65% 0.25%
NA NA NA NA NA 2.460 0.073
NA NA NA NA NA 0051 0.034
10 13 16 23 25 30 39
2 2 3 3 4 4 5
20 00% 15.38% 18 75% 13.04% 16.00% 13.33% 12.82%
Pacific Funds vs. Lipper

Pacific Region IPX
50.73% -4 57% 3 25% 6 19% 1 87% NA NA 15.63%
3098 -1 518 1 168 0038 0024 NA NA 0 123
0.164 0.030 0028 1 619 0781 NA NA 1 276
46 51 71 46 30 NA NA 46
5 7 8 5 4 NA NA 5
10 87% 13 73% 11 27% 10 87% 13 33% NA NA 10 87%
The one-year time periods that had statistically significant results were 1997 and 1999.
These two time periods had positive coefficients showing that mutual funds with
redemption fees added benefit to mutual fund performance. The coefficients were not
only statistically significant, but were also quite large. In 1997. the coefficient was
12.65% and in 1999. the coefficient was 50.73%. This tells us that on average, pacific
mutual funds w ith redemption fees in the 1999 tim e period outperformed the index by
50.73%. However, it must be noted that in 1997. o n ly four mutual funds (16 percent) had
redemption fees and in 1999 only five mutual funds (11 percent) had redemption fees.
Therefore, a few strong performing mutual funds could be skewing the results.
79
The sample sizes for the three- and tlve-vear annualized returns along w ith the Sharpe
Ratio were large enough to warrant a regression. W hile all the coefficients in these
regressions were positive, no regression had statistically significant results.
The effects of redemption fees on expense ratios

In this section, the expense ratios for the entire sample were regressed against the
redemption fees to see i f redemption fees had some sort o f an effect on expense ratios.
iMutual funds that did not have a redemption fee regressed a zero for the fee and those
mutual funds that had redemption fees, had the actual fee regressed against the expense
ratio. A t the time o f this w ritin g , not all mutual funds from the original sample o f 2.579
funds had expense ratios reported either by Momingstar or in the published prospectus.
This reduced the total sample size to 2.079 mutual funds. O f the 2.079 funds. 231 funds,
or eleven percent o f the funds had redemption fees. The results from this regression are
reported in table eleven.
Table 11: Redemption fee effects on expense ratios
Expense Ratio Results

0.02% 101.524 0.000
0.23% 6.678 0.034
The results report that redemption fees do have a significant positive impact on expense
ratios. The redemption fee has a statistically significant positive coefficient o f 23 basis
points. This tells us that on average, for even,’ one percent increase in redemption fees,
expense ratios increase by 23 basis points. Considering the reported average expense
80
ratio for equity mutual funds is 1.52 percent (this paper had an average expense ratio o f
1.63 percent), this is quite a large impact. In fact. 23 basis points is 15 percent o f the
reported average expense ratio and 14 percent o f the average expense ratio in the sample
for this analysis.
W ith these results comes the question o f why redemption fees, on average, lead to higher
expense ratios. The answer may have to do with the mutual fund itself. Many mutual
funds that impose a redemption fee may also be new mutual funds trying to accumulate
assets in order to grow in size. New mutual funds typically also have higher expense
ratios to accommodate for operational growth. As it turns out. when looking at the
sample, two mutual funds in the Turner fam ily charged the m axim um o f two percent for
redemption fees and also charged expense ratios o f 6.01 and 9.77 percent. These expense
ratios are very large (the two largest in this sample) and when eliminated, the average
expense ratio for the remaining sample drops one basis point to 1.62 percent. These two
mutual funds which are skewing results also have small asset bases. In fact, one has less
than two m illio n dollars under management. Thus, smaller mutual funds may have
higher expense ratios and redemption fees. When removing these two mutual funds, the
redemption fee coefficient falls to 0.172 percent and it is still statistically significant.
Previous papers have shown that mutual fund size and age are negatively related to
expense ratios. A n interesting continuation to this paper would be to see i f redemption
fees are correlated to the asset size o f a mutual fund and/or the age o f the mutual fund
81
w hich would help explain w hy mutual funds w ith redemption fees, on average, have
higher expense ratios.
82
VII. Interpretations and Conclusions
The intent o f this paper was to see i f redemption fees afYected mutual fund performance.
It was anticipated that mutual funds w ith redemption fees had less cash flow s as these
funds targeted investors w ith a lesser need for liq u id ity. Fewer cash flows a llo w fund
stability and the opportunity for the fund manager to focus on performance rather than
cash flows, thus leading to better performance.
There were a total o f 94 regressions run for this analysis, excluding the micro cap style
since it did not have the m inim um sample requirement o f 30 mutual funds that was set for
this analysis. Twenty-three o f the 94 regressions (24 percent) were statistically
significant at the 95 percent level. O f the total 94 regressions. 18 o f the statistically
significant regressions (19 percent) showed redemption fees contributing to mutual fund
performance in a positive way. Three statistically significant regressions (three percent
o f all regressions) resulted in redemption fees affecting mutual fund performance in a
negative way. The two remaining statistically significant tests were the tests run for the
Sharpe measure. Both o f the coefficients for these tests were positive showing that
redemption fees contribute to higher risk-adjusted returns.
Six o f the 30 statistically significant regressions (20 percent) were related to annualized
returns. A ll o f these significant tests resulted in positive coefficients for the redemption
fee. meaning that redemption fees were contributable to excess returns over the
applicable benchmark.
83
The analysis o f the total sample resulted in some coefficients that support the idea that
redemption fees add value to fund returns, but many o f the results from the total sample
regressions were simply unlikely. The coefficients for the total sample showed some
cases where mutual funds w ith redemption fees result in greater returns and risk-adjusted
returns than those mutual funds w ithout redemption fees. Seven o f the fourteen
regressions run for the total sample resulted in statistically significant positive
coefficients whereas one was negative. Even more interesting is all three annualized
returns and the Sharpe measure were statistically significant and resulted in positive
redemption-fee coefficients. Although some o f the statistically significant coefficients
were arguably large, these tests d id show some evidence that for our sample, redemption
fees add value to mutual fund performance.
Although the regressions resulted in some statistically significant results, the large cap
growth and value styles sim ply did not have a large enough sample o f mutual funds w ith
redemption fees to come to any solid conclusions regarding redemption fee effects on
performance.
The small cap styles also had inconclusive results. For the small cap growth category,
two time periods had statistically significant results, but one period was driven by just
two mutual funds with redemption fees. This leaves only one time period where mutual
funds w ith redemption fees appear to have added benefit to a mutual fund return. The
small cap value style had regressions that had significant results for two calendar-year
84
returns w ith one positive coefficient and one negative coefficient. However, more
im portantly, the three- and five-year annualized return along w ith the three-vear Sharpe
measure had statistically significant positive coefficients.
The healthcare/biotechnology style had only one statistically significant time period
resulting in a positive coefficient. However, the annualized returns were all insignificant
and one calendar time period with a significant result is clearly not convincing enough to
say that redemption fees added benefit to this style.
The technology category was expected to be the most likely category to show redemption
fees affecting mutual fund performance in a positive way. This was expected for two
reasons. First, this category had a large percent o f the total mutual funds charging
redemption fees to its short-time shareholders, allowing us to get some depth in the
analysis. Second, all the statistically significant one-vear returns reported positive
coefficients im plying that for this sample, redemption fees affected performance in the
technology style in a positive way. S till, two positive coefficients are not enough
evidence to report that redemption fees contribute to excess returns. Also, it is important
to note that no annualized period resulted in statistically significant results.
The m icro cap and communication styles sim ply do not have enough data to conclude
whether or not redemption fees affect performance. The m icro cap style does not have
enough funds in the style as a whole. In fact, in the final year o f our analysis, the micro
cap style only had 13 applicable mutual funds. The communications style finally had
85
enough funds (sample size o f 49) in the final one-year period to deserve a regression.
Therefore, going forward, this style now has enough funds to analyze: it just needs to
accumulate the returns. In tim e we w ill be able to see how redemption fees affect these
two styles. They w ill both be worth revisiting in the future.
Like the other mutual fund styles, the pacific category did not produce any solid results to
show that redemption fees contribute to excess returns. O nly two statistically significant
regressions existed in this category, which were the calendar returns ending 1997 and
1999. While the coefficients for these two tests were quite large, there is still not enough
evidence to state that redemption fees added value to this category. Notably, none o f the
annualized tests resulted in statistically significant coefficients.
Like Dellva and Olson (1998). we found some evidence that mutual funds w ith
redemption fees, on average, earn higher risk adjusted returns along w ith evidence o f
redemption fees positively affecting excess returns. However, we did not find consistent
evidence that redemption fees contribute to mutual fund returns or risk-adjusted returns.
In regard to the effects redemption fees have on mutual fund expense ratios, the results
tell us that there is a positive, direct, relationship between redemption fees and expense
ratios. The one regression conducted was significant and the coefficient was positive.
As mentioned, the positive relationship between redemption fees and expense ratios may
have to do with the mutual fund itself as these mutual funds may be new and therefore
86
trying to accumulate assets to grow in size. New mutual funds typically have higher
expense ratios to accommodate for growth in operations. This would make sense as
previous papers have shown that fund size and age are negatively related to expense
ratios.
Considerations
There are several items which must be considered w ith this analysis mam stemming
from this analysis being a single variable rather than m ultiple variable regression
analysis.
First, we need to know whether or not a mutual fund company actually upholds the
redemption fee. For example, the fee may be waived i f the dollars are transferred into
another mutual fund within the same mutual fund fam ily. I f the fees are waived, the
a b ility o f the fee to reduce cash Hows diminishes. This would be especially true i f the
number o f funds in a family were large and robust. Some companies may even allow the
investor to ju m p from fund to fund w ithin the same fa m ily several times and only charge
a redemption fee i f the dollars were removed from the mutual fund family altogether
w ith in a certain time period.
T im ing plays an important role in this analysis and redemption fees are relatively new.
Although the concept has been around for quite some time, the fees have recently gained
popularity w ith mutual fund managers. Therefore, due to the recent popularity the effect
87
that these fees have on fund performance may not yet be reflected. The recent popularity
in redemption fees would prevent us from seeing the effects in the long term, but may
give a view o f short term results (one-vear analysis). Perhaps it would be better to take
another look at this analysis five years from now.
Furthermore, there s till may be confusion in the financial markets as to what a
redemption fee is exactly. As noted earlier, the redemption fee information was gathered
from M om ingstar's database. This database was found to be inconsistent w ith individual
mutual fund prospectuses. In fact, much o f the data had to be pulled from individual fund
prospectuses from individual mutual fund fam ilies. The inconsistency may be due to
fund representatives not understanding the d e fin ition o f redemption fees and the
differences between redemption fees and back-end loads. Many o f the larger fund
companies had individual lines in their prospectuses for redemption fees, but not all
managers appeared to recognize the difference. A benefit going forward w ould be to
have an investment company track this inform ation more tightly. Lipper provides
redemption fee inform ation, but it costs $1,500. As o f this paper. M om ingstar was the
only company which tracked the information as part o f their regular service.
Another variable to consider is the fact that some mutual funds charge fiat redemption
fees rather than a percentage o f assets. M any prospectuses showed a fiat $ 10 to $50
charge for w ithdraw ing from the mutual fund. Some o f these charges did not disappear
in time, but would be charged no matter the tim e o f the redemption. This flat fee may
represent the costs for sending a check or w ire but they were still referred to as a
88
redemption fee. This paper did not factor in those mutual funds that charge a flat
redemption fee. This paper only considered those redemption fees that were listed as a
percentage o f assets.
Many market timers do see the redemption fee as a moderate deterrent, since such exit
charges obviously reduce net performance. Fund speculators, however, can realistically
generate profits large enough to compensate for the redemption fees. In these cases, the
redemption fees w ill not be effective enough to fend o f f these speculators. In short, i f the
short tim er can generate high enough returns, the speculator w ill live w ith the redemption
fee and pay it.
Extensions to this paper
There are several possible extensions to this paper. One would be to analyze the
expiration tim e period for redemption fees. Some m utual funds charge the redemption
fee for 90 days, while other mutual funds charge the fee for up to five years. It is
anticipated that the funds w ith a longer expiration should have more solid cash flows. It
w ould be interesting to see the relationship betw een the tim e o f expiration versus a fund's
cash flows.
A second interesting addition to this paper would be to find what determinants drive
redemption fees. Kihn (1996) identifies some o f the determinants o f front-end loads to
be expected returns, past returns, the age o f the mutual fund, marketing charges, along
89
w ith some other variables. It would be interesting to see i f there is a relationship between
variables such as these along w ith total asset size and redemption fees.
A third extension would be to see i f lo w liq u id ity investors tend to invest in mutual funds
w ith redemption fees. In other words, do mutual funds w ith redemption fees indeed
attract the low liq u id ity investors that are being targeted? This would ultimately be a
study o f the relationship between redemption fees and cash flows. It would be expected
that funds with redemption fees, on average, have fewer fund flows (at least outflow s)
than those funds without redemption fees. This analysis would be challenging as it
w ould require the need to get individual monthly, quarterly, and/or yearly mutual fund
cash tlows (which may not be published), and see i f there is a relationship between the
flow s and redemption fees.
A fourth extension to this paper would be to perform a m ultiple variable analysis rather
than ju st a single variable analysis. T his could consist o f several variables, including,
w hether or not a fund is part o f a fund fam ily, age o f the mutual fund, size o f the mutual
fund, the transparency o f the redemption fee. and whether or not a redemption fee is fu lly
enforced.
In regard to the effects that redemption fees have on expense ratios, a continuation to this
paper would be to see i f redemption fees are correlated to the asset size o f a mutual fund
and/or the age o f the fund which would help explain why mutual funds w ith redemption
fees on average have higher expense ratios. A simple regression could be done to see i f
90
the age o f a fund and the total asset size o f a fund have any effect on whether or not a
fund has a redemption fee. I f redemption fees are found to have an effect, a continuation
o f that analysis w ould be to see the size o f the effect. In other words, to what level do
these two variables cause redemption fees to increase or decrease?
Conclusions
In conclusion, the analysis did not find any solid results showing that redemption fees
affect mutual fund performance. Some tests were found to have positive or negative
influence, but not enough statistically significant tests were found to state that redemption
fees affect mutual fund performance.
Like any analysis, the accuracy o f the data must be questioned. To verify the accuracy, a
spot check o f ten percent o f the data was performed. The check was compared to what
was being reported by Lipper versus what was reported in the Momingstar database in
regards to returns to ensure that reported performance was correct. The results o f the spot
check indicated that in my small sample, only 89 percent showed accurate data. It was
found that nine percent o f the returns were actually net returns rather than gross returns.
Tw o mutual funds (from the ProFunds fa m ily) that were checked were not even remotely
close to what M om ingstar was reporting. ProFunds had two funds that were reported by
Lipper as earning over 200 percent for the one year ending December 2001. M om ingstar
reported a loss in these two funds o f over 30 percent. I then verified the returns at
ProFund's website. The website verified Momingstar was correct and Lipper was
91
incorrect. This verifies that there are some discrepancies in the performance data that
was used.
Lastly, two percent o f the funds from the spotted sample actually had higher net returns
than gross returns. Unless the manager is paying the investor to invest in the fund, which
is not very likely, this is not possible. What is possible is the data that was reported to
Lipper by mutual fund firm s accidentally got reversed. There is a large window for error
in regard to reporting mutual fund returns. The investment company must first report the
returns correctly to the data reporter (in this case Lipper) and then the data reporter must
correctly enter the returns into their system.
In summary , we cannot conclude that redemption fees affect mutual fund performance.
W e did not have enough results to make that statement nor were we confident enough
that the data used was accurate enough to draw to any solid conclusions. Therefore, the
null hypothesis is not rejected and redemption fees did not prove to contribute to (or take
away from) mutual fund performance.
A note on closed-ended m utual funds:
Although only open-ended mutual funds are being considered for this analysis, closed-
ended mutual funds are worth discussing as a means to reduce fund cash flows. Total
assets in closed-ended mutual funds were $165 m illio n as o f the end o f 1999. for a total
92
o f 495 mutual funds. O f this total. $64 m illio n (39 percent) were invested in equity
closed-ended funds for a total o f 122 funds.
Closed-ended funds would be an alternative to using redemption fees to avoid liq u id ity
shocks. Closed-ended funds trade sim ilar to equity stocks. These funds allow investors
to meet their needs by selling their fund shares in the secondary market, rather than
pulling assets away from the fund. Therefore, liquidity shocks do not affect assets
managed by a closed-ended fund, creating a liquidity advantage for the manager and
allowing the manager to be more efficient.
The negative side to these mutual funds is similar to trading stocks, as trading these
mutual funds generates transaction costs when the investor buys or sells the fund. M ost
open-ended mutual funds do not charge a transaction cost i f the investor holds the fund
for a certain defined time period.
Another dow nfall to closed-ended mutual funds is they may not satisfy the level o f
liquidity needed by the individual investor. In order to sell, there must be a buyer,
whereas open-ended mutual funds a llo w withdrawal at any time. Not being able to sell
your mutual fund immediately may leave the investor at the mercy o f a poor manager.
An important consideration for investors is to identify a manager who has proven a b ility ,
which w ill in turn cause the mutual fund to be more liquid.
93
Closed-ended mutual funds also do not a llo w the investor to continually invest in the
fund as money and inform ation become available unless there are shares to be purchased.
Open-ended mutual funds a llo w continual inflow s into the mutual fund, unless o f course
the mutual fund closes due to overall substantial asset size.
94
VIII. References
Carhart. M .. 1997. On persistence in mutual fund performance. The Journal o f Finance

52. no. 1. 57-82.
Chordia. T.. 1996. The structure o f mutual fund charges. Journal o f Financial
Economics 41. 3-39.
Cooley. S.. 1998. Revisiting Fund Costs: Up or D ow n? Momingstar. Incorporated.
Available from: http://news.momingstar.com/nevvs/MS/Commentan7990219com.html
(Accessed December 2001)
Dellva. W. and Olson. G.. 1998. The relationship between mutual fund fees and
expenses and their effects on performance. The F in a n c ia l Review 33. 85-104.
Di Teresa. P.. 2001. A fe e that s good f o r investors. Momingstar. Incorporated.
Available from: www.morningstar.com (Accessed October 2001)
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Lengthen. While Fees Remain Constant. Financial Research Corporation. Available
from: http: www.frcnet.com f r c research articles, a rt_ p rc Jee.asp
(Accessed October 2001)
Edelen. R.. 1999. Investor Hows and the assessed performance o f open-end mutual
funds. Journal o f F in an cial Economics 53. 43-466.
Fant. F.. 1999. Investment behavior o f mutual fund shareholders: the evidence from
aggregate fund Hows. Jo u rn al o f F in an cial M arkets 2. 391-402.
Ferris. S. and Chance. D.. 1997. The effect o f 12b-1 plans on mutual fund expense ratios:
A note. The Journal o f Finance 42. no. 4. 1077-82.
Gruber. M .. 1996. Another puzzle: The growth in actively managed mutual funds.
J o u rn a l o f Finance 51. 783-810.
Hooks. J.. 1996. The effect o f loads and expenses on open-end mutual fund returns.
J o u rn a l o f Business Research 36. 199-202.
Investment Company Institute. 2002. M u tu al Fund F a c t B o o k 2002 Edition. Available
from : http://wAvw.ici.org/aboutfunds/factbook02_toc.html (Accessed July 2002)
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from : http://wAVAv.ici.org/aboutfunds/factbook01_toc.html (Accessed February 2002)
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performance. 1965-1984. The Q u arterly Journ al o f Economics 104, no. 1. 1-23.
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Nanda. V.. Narayanan. M .. and Warther. V .. 2000. Liquidity, investment ability, and
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Oversize materials (e.g., maps, drawings, charts) are reproduced by

ProQuest Information and Learning

A Study of the Effects of Redemption Fees on Mutual Fund Performance

Dr. Thomas Cargill Thesis A dvisor

D r. Sheri Faircloth C om m ittee M em ber

D r. Elliott Parker Com m ittee M em ber

ProQuest Information and Learning Company

We recommend that the thesis

A STUDY OF THE EFFECTS OF REDEMPTION FEES

be accepted in partial fu lfillm e n t o f the

Thomas C a rgill, PhJJ> rfA d viso r

o /k tv < T & l. uc le t!-~

E llio tt Parker, Ph. D . , A t-Large Member

Marsha H. Read, Ph. D., Associate Dean, Graduate School

A Study of the Effects of Redemption Fees on Mutual Fund

II. THE EQUITY MUTUAL FUND INDUSTRY___________ 11

III. LITERATURE REVIEW _________ 20

IV. SUMMARY OF THE DATA 41

Technology' re s u lts _________________________________________________________________________________________ ~3

VII. INTERPRETATIONS AND CONCLUSIONS_______________________________________ 82

T a b l e 1: E n t ir e sam ple versus L ip p e r 1000 benchmark ___________________________ 61

T a b l e 10: P a c if ic funds ver su s the L ip p e r p a c if ic r e g io n b e n c h m a r k ___________ 78

in an employer-sponsored defined contribution plan. Furthermore, the typical mutual

third o f household financial assets. Seven out o f eight shareholder households

401 (k) plans by age.

Figure I: Average 401(k) Savings by Age

Average 401(k) Savings by Age

S $ 100,000 $200,000 $300,000 $400,000 $500,000 $600,000

add value to mutual funds.

Some clarification as to the definition o f redemption fees is needed before we continue.

which is considered to be a sales load. In addition, a mutual fund is permitted to charge

weighted average 12b-1 fee o f 77 basis points.

For clarification. 12 b -1 fees are defined as costs being used to cover

contributed to an increase in management expenses (Ferris and Chance 1987). Kihn

1 fees by 51 basis points. Although it w ill not be considered in this analysis, it is

dollar amount or as a percentage o f the redemption price."

punish market timers.

sample used to conduct this analysis.

(see figure two).

Figure 2: Average redemption fee and expiration period over time

Vvcragc Redemption Lee Provisions

: ( h.K-V I cru:t.;i ; m ifd s

Source: Financial Research Corporation (Whitney Dow)

investments. The redemption fee is frequently attached to a mutual fund in order to

creating losses and. in turn, punishing the long-term investors.

to cover fo r the short timers.

H„: Redemption fees do not affect mutual fund performance

Ha: Redemption fees do affect mutual fund performance

performance, as these funds tend to be long-term investments naturally because o f their

predictability and stability. Therefore, there w ill be no added benefit to holding

Equity mutual funds continued to be an important investment vehicle for long-term

whole and equity funds separated.

m illio n to market investments once the risk o f further attacks subsided.

Figure 3: Total Fund and Equity Only Assets 1970-2001

Total Fund Assets 1970-2001

7,500,000 ------------ ------------------------------------------------------- ---------

Total N«t Asstts — Equity Net Assets

YOY Asset Growth 1970-2001

“ ““ Total NX Assets " Equity N ft Asstta

decrease o f 90 percent from 2000.

Figure 5: Components of M utual Fund Growth 1990-2000

Components of Mutual Fund Growth: 1990-2000

Source investment Com pany institute

2000 probably due to their lower risk investment objective.