Exit fees in times of market stress: A solution in search of a problem

When markets go haywire, investors often follow suit. Indeed one of the overriding themes in the pages of InvestmentNews over the last few weeks, ever since the Aug. 24 opening-bell drop of more than 1,000 points on the Dow Jones Industrial Average, has been that advisers should be preaching — and exhibiting — calm in the storm.

Unfortunately, regulators can sometimes go off the rails, too, and it would seem the late-summer spike in market volatility caused havoc at the Securities and Exchange Commission.

According to published reports, the SEC on Tuesday will consider a rule allowing mutual fund companies to charge investors who withdraw funds during periods of market stress. Bloomberg News reported that SEC officials think the fee could douse investors’ impulse to cut and run when the market gets ugly.

VALID CONCERN

Regulators’ concern is valid. After all, with $16 trillion or so in assets invested in them, mutual funds control a huge chunk of money. So if, for some reason, millions of investors decided all at once to sell their mutual fund shares, there could be a problem.

The issue of liquidity — investors’ ability to get in and out of their investments — is not new but made headlines again last month when stocks were bouncing all around like a yo-yo. As the Dow industrials dropped like a stone, worry over a stampede emerged, and it has not diminished even though stock prices soon recovered. The market’s volatility in the ensuing days didn’t quell anyone’s fears.

Hypothetically, a mass rush to mutual fund exits could force fund managers to sell positions to raise cash to meet redemptions. Selling would lead to more selling and markets could seize up.

So when the stock market opens with a four-digit point decline and a computer glitch at the world’s largest custody bank prevents timely pricing of hundreds of exchange-traded funds and mutual funds, investors and regulators can be forgiven for worrying about liquidity.

But the idea of allowing mutual funds to flip a switch and turn on exit fees on a moment’s notice seems reactionary and short-sighted.

Sure, such a fee might make investors pause before pulling the sell trigger. But unless the fee is insanely high, it’s not likely to change behavior. It may make investors pause for a moment but anyone intent on getting out of a fund is going to get out no matter what.

As behavioral finance experts frequently remind us, the pain of loss is much greater than the joy of gain. An exit fee is a small price to pay to reduce that pain.

Then there are the details to consider. Who defines and what is the definition of a stressed market that would trigger the exit fee? Would it work like the circuit breakers that stock exchanges have for halting or limiting trading when major indexes drop by a certain percentage? Would it be some blanket number across markets or be divided by industry or mutual fund categories? At what point would the trigger be turned off?

Take Aug. 24, for example. The Dow dropped 1,089 points in the opening minutes. Say that big a decline would be enough to set off the mutual fund exit fee. But then the market recovered and the Dow closed off 600 points, recovering more than 40% of its original drop. Would exit fees still be in effect with that kind of recovery? Once the fee is triggered, does it stay on for one day? One week?

It’s an important question, since mutual funds trade once a day at the close.

To be sure, mutual funds faced with a wave of selling from investors suffer from a spike in their own costs as fund managers sell securities to meet those redemptions. An argument could be made that those funds should be able to pass those costs onto the very investors who are selling. But isn’t that really a cost of doing business?

OPPOSITE EFFECT?

In addition, exit penalties might increase, not decrease, volatility. Once investors know they’ll be hit with a high cost to exit a fund if things get volatile they may simply sell earlier, which could then trigger more selling and the ball starts rolling downhill.

The issue of liquidity — or lack thereof — is real, and regulators, in conjunction with the fund industry, should be examining ways to prevent markets from freezing up when liquidity dries up. But the idea of an exit fee in times of market stress appears to be a solution in search of a problem.