In the debate about transparency of fund charges there is one charge that is rarely mentioned. It’s application is left to the judgement of those running the fund, as is its level, which can vary from one day to the next, and, potentially, it inflates a fund’s performance record and misleads investors as to the returns they could have made. This charge is the dilution levy.
Where an investor either puts new money into a fund or withdraws money from the fund, then these money flows may result directly in portfolio transactions which have costs. The dilution levy seeks to isolate such costs and have the transacting investor bear them rather than the other unitholders.
In theory, this is fair to all parties. However, in practice, it can be extremely complex to administer. For fund flows which are insignificant to the size of the fund, for example a £10,000 inflow into a £1 billion fund, there may be no immediate portfolio transactions to reflect the inflow, and so a dilution levy would not reflect actual costs incurred. Or, more commonly, on any day there are both inflows and outflows to the fund that offset each other, again resulting in no portfolio transactions. If a dilution levy is charged, then establishing the cost or impact to the fund can be a complex calculation requiring assumptions to be made. Typically the dilution levy is only made known to the unitholder affected (sometimes before the transaction, sometimes only afterwards), not to other unitholders until an Annual Report is published, many months later. The application of the dilution levy always acts to reduce the total return of the fund to the investor making the transaction.
Dilution levies are most commonly applied where funds are invested in less liquid asset classes, most typically property and corporate bonds, though since the last crisis, property funds have tended to run with high levels of cash to meet a surge in redemptions. Emerging markets and smaller companies are other areas where a liquidity crisis could emerge in the future.
The legal and regulatory wording for dilution levies found in fund prospectuses and the FCA Handbook leave much room for discretion for those running the funds, and there are four reasons to believe that dilution levies may become more prevalent in the future.
Firstly, the easy monetary policies pursued around the globe in recent years have created good liquidity conditions for financial markets, with inflows into funds being far greater than outflows – dilution levies are more commonly applied to redemptions than new fund purchases. A reversal of such easy monetary policies may lead to lower net fund flows and poorer market liquidity.
Secondly, in an increasingly litigious and regulatory-minded society, fund investors may become more assertive of their rights to be protected from the activities of incoming and outgoing investors, and fund lawyers and compliance officers will be likely to behave in a defensive manner and impose dilution levies more than might be practically required.
Thirdly, fund management companies have an incentive to impose dilution levies that are higher than strictly necessary. Though they themselves will not benefit directly from a dilution levy that is greater than necessary, the track record of their funds will. This may result in a higher bonus for the fund portfolio manager and in the longer term greater inflows into the fund and thus higher management fees.
Finally, the increasing consolidation of the wealth management industry, and the rising use of centralised investment models within wealth managers is leading to a greater concentration of ownership of funds and also more active management and rebalancing of fund portfolios. The wealth management industry is thus likely to generate a greater turnover of their fund holdings and when they do make changes to their models, it will lead to greater transaction sizes than has been seen in the past, and so dilution levies may become more prevalent. This will represent an important diseconomy of scale for the wealth management industry.
This article originally appeared in Investment Adviser magazine
