Hidden Costs of Fund Investing

In the debate about transparency of fund charges there is one charge that is rarely mentioned - this charge is the dilution levy

Jeremy Beckwith 19 February, 2015 | 11:59AM
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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.

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Jeremy Beckwith  is Director of Manager Research for Morningstar UK

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