Mon, 01/03/2004 - 07:01
The SEC this week voted to propose a new Rule 22c-2 under the Investment
Company Act of 1940 in an attempt to curb market timing by hedge funds.
The proposed rule would require all mutual funds to impose a 2 percent fee on
the redemption proceeds of shares redeemed within 5 days of their purchase.
The fund itself would retain the proceeds from the redemption fees.
The rule is designed to require short-term shareholders to reimburse the fund for
the direct and indirect costs that the fund pays to redeem these investors' shares.
In the past, these costs generally have been borne by the fund and its long-term
shareholders. Thus the redemption fee would be a "user fee" to reimburse the
fund for the cost of accommodating frequent traders such as hedge funds
The proposed rule includes several provisions designed to prevent the fee from
affecting most ordinary redemption transactions by smaller investors:
First, the rule requires that a fund calculate the redemption fee on shares held
the longest period of time first. This method will minimize the likelihood that
redemptions of part of a shareholder's account will be assessed a redemption
Second, the rule would include a de minimis exception - the fund would not be
required to impose a redemption fee of $50 or less. This means that a fund could
waive redemption fees on the redemption of $2,500 or less in fund shares.
Third, the rule would include an emergency exception that would allow a
shareholder not to pay a redemption fee in the event of an unanticipated financial
emergency. This means that at least $10,000 would be available to a
shareholder in a financial emergency and no redemption fee would be charged.
The rule would not apply to money market funds and exchange-traded funds. It
also would not apply to mutual funds that encourage active trading and disclose
to investors in the prospectus that such trading will likely impose costs on the
Many funds today that impose redemption fees do not impose them on
shareholders who hold their shares through financial intermediaries such as
broker-dealers and retirement plans. These intermediaries often are reluctant to
provide enough shareholder information to the fund to allow it to assess the
redemption fee. The proposed rule would require that funds obtain the
information they need to assess the redemption fee, and to oversee the efforts of
intermediaries to assess those fees and remit them to the fund.
The rule would supplement other measures the Commission has recently taken
to address short-term trading, including abusive market timing activity. It is not
designed to be an exclusive cure for the problem of abusive market timing, which
will often (but need not) involve rapid trading strategies. Conversely, the proposal
is not designed to solely address large traders. The costs imposed on long-term
investors in funds by the cumulative effect of many smaller short-term traders
may be greater than those imposed by a few large traders. If adopted, the
proposal would allow funds to recoup some, if not all, of these costs.
The principal solution to abusive market timing transactions is the accurate
calculation of net asset value each day, using current and not stale prices.
Accordingly, the Commission made clear in a release last December that the
Investment Company Act of 1940 requires funds to calculate their net asset value
based on the "fair value" of a portfolio security if the market quotes are
unavailable or unreliable.
Although fair value pricing can reduce the profits that market timers seek to
extract from mutual funds, it is subjective in nature. Thus a redemption fee,
together with fair value pricing, can serve to reduce, if not eliminate, the profits
that market timers seek to extract from the fund. The release would request
comment on how funds can more effectively implement fair value pricing
methods, and whether the Commission should provide further guidance in this
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