A Necessary Evil

[Entry and Exit Fees Explained]

Source: 2000 4Q Commentary

Iacocca Was Wrong

"When the product is right," Lee Iacocca once observed, "you don't have to be a great marketer." With due respect, Iacocca was wrong. While we'd never claim that the mutual funds that TIFF administers are perfect in design and management, we do believe that at least one initial design choice made long ago remains unarguably sound. Ironically, the policy in question has proven as unhelpful in a marketing sense as it has helpful in vouchsafing our members' interests. The policy to which we're alluding is the levying of transactions charges on cash flows into or out of TIFF's equity-oriented mutual funds. The discussion of such charges that follows seeks to help trustees better understand why TIFF insists on safeguarding its members' interests in this manner. [1]

Offputting but Essential

The generally strong relative performance of the TIFF funds in recent years has spawned heightened interest in them among eligible charities. This is a welcome development in TIFF's eyes, because in contrast to TIFF's private equity and absolute return-oriented offerings its mutual funds could readily and immediately accommodate new members and assets without sacrificing return potential. That said, the current wave of interest in TIFF's mutual funds does pose a problem for staff, albeit one of its own making. Since their inception, those TIFF-sponsored mutual funds that invest routinely in equities have levied transaction charges aimed at making participating non-profits pay their fair share of trading costs generated by their comings and goings. When staff proposed to TIFF's founding board that it approve the levying of such charges, it knew full well that they would prove offputting to some eligible charities. It knew also that some folks would confuse such fees with "loads" — the loathsome tolls that some mutual fund sponsors stuff into their own pockets when money flows into (and in some cases out of) the funds that they administer. Because they get paid to the TIFF funds themselves, rather than to TIFF or persons associated with it, the transaction charges levied by TIFF's equity-oriented mutual funds have nothing in common with "loads" (except a tendency to repel certain investors). Indeed, their raison d'être is wholly different from the aims underlying "loads," which exist solely to generate profits for fund sponsors. TIFF's entry and exit charges exist solely to compensate non-transacting members for the costs that they would otherwise be forced to bear when cash flows into or out of such funds.

Frictional Costs

Regardless of whether an endowed organization invests via commingled vehicles or separate accounts, it incurs costs when converting cash into portfolio securities or vice versa. These costs fall into four distinct categories, three of which are susceptible of precise measurement and one of which is not. The measurable costs are (1) brokerage commissions, (2) custodial bank charges, and (3) applicable government fees. Though not insignificant, these costs of doing business tend to pale in comparison to the other, generally unmeasurable cost that investors incur when buying and selling securities: "market impact." Market impact means the incremental wealth that one party to a trade must transfer to the contra party to bring the trade to fruition; it is generally unmeasurable because security prices tend to fluctuate throughout each trading day in response to multiple factors, most of them unrelated to the needs or motives of the two parties involved in a given trade. For example, if my broker tells me that a stock I seek to buy is "$49.75 bid, $50.25 offered" at 10 a.m. on a given day, and I ultimately end up buying the stock at $50 at 10:15 a.m., I cannot simply infer that "market impact" cost me $0.25 per share (i.e., my purchase price of $50 less the pre-existing "bid" of $49.75). After all, between the time I place my order and the time it gets filled, exogenous events could cause other investors to place their own orders to trade the stock in question, causing its price to change for reasons unrelated to my own activity. This is true even if the lag between my placement of an order and its execution is very brief.

Unknowable but Not Immaterial

Of course, with respect to isolated trades (especially those involving very thinly traded stocks), I can probably estimate my "market impact" with reasonable accuracy. But with respect to a series of trades involving many different securities, there is no way of measuring precisely what we've referred to here as "market impact." But we do know from analysis and experience that, at least with respect to stock trades, "market impact" is anything but immaterial. Of course, materiality like beauty lies in the eyes of the beholder. But as TIFF beholds its members' investable wealth, the $0.25 per share of "market impact" cited in the above example is hardly immaterial, equating as it does to 0.50% of the recorded purchase price of $50 per share. To be sure, the estimated "market impact" of the typical US stock trade is less than 0.50%, but as noted in the table below the total costs of the average trade (including commissions and other frictional costs) are not much below 0.50%, and "market impact" alone can be far higher with respect to some trades.

Wired World

The ease with which investors in today's wired world can trade securities causes some folks to conclude that stocks can be bought and sold essentially for "free." This mistaken impression is reinforced by today's staggeringly high trading volumes, which seduce some folks into believing that their relatively small trades can't possibly "move the market." Obviously, viewed in isolation, one individual investor's decision to sell a small block of shares of a liquid stock such as Cisco cannot be said to "move the market." But viewing in isolation anything having to do with investments is perilous indeed, and it would be unwise for trustee groups to assume that they can buy and sell stocks at will without incurring frictional costs. This admonition applies to separate accounts as well as commingled vehicles, including the many mutual funds that prefer to submerge rather than highlight (as does TIFF) the costs of facilitating shareholders' ins and outs. Returning to our Cisco example, it should be obvious that a decision by a mutual fund behemoth like Fidelity to sell even part of its gigantic block of Cisco shares will indeed "move the market." And to the extent that Fidelity's sell decision is motivated not by its perception that Cisco shares are overvalued but rather by the need to raise cash to finance mutual fund redemptions, the non-redeeming shareholders will suffer as a result of the downward price pressures created by the exiting holders' decision to bail. The deleterious effect of mutual fund inflows is perhaps a bit harder to discern because "buys" put upward price pressures on portfolio holdings that assumedly redound to the benefit of a fund's pre-existing investors. But, sticking with our example, if mutual fund inflows rather than changed fundamentals are the sole reason Fidelity is buying a big slug of Cisco on any given day, the safe assumption is that it will be forced to "pay up" to get other Cisco holders to part with their shares. Unless Fidelity charges entering mutual fund investors an entry fee — which it and most of its competitors do on shockingly few funds — the pre-existing holders of the fund buying Cisco will get socked with costs that they should not properly bear.

Timing Is Everything

The inherent unfairness of not levying explicit charges on mutual fund purchases and redemptions is exacerbated by the peculiar way in which shareholder ins and outs are reflected on a mutual fund's books. As many readers are aware, most equity trades "settle" one day after the trades themselves have been executed. In other words, if a manager employed by the TIFF US Equity Fund sells 10,000 shares of Company XYZ at $50 per share on a given Monday afternoon in order to raise cash to meet a foundation's urgent redemption request received by TIFF that morning, the shares will remain in the Fund's possession until Tuesday. Sometime on Tuesday, ownership of the shares will transfer to the buyer (through the medium of an automated clearing house), with the Fund receiving about $500,000 in "cash." We say "about $500,000" because the ultimate proceeds will be reduced by the three measurable forms of expense identified above (commissions, custodial bank fees, and relevant governmental levies). Moreover, the $50 per share proceeds assumedly reflect real but unknowable "market impact" as defined above. Now consider this question: when does the redeeming foundation in our example get priced out of the Fund? The answer is, "At the Fund's close of business on Monday." As can be seen, if the redeeming member gets priced out on Monday night but the securities sales triggered by its redemption aren't booked until Tuesday (for reasons lying totally beyond TIFF's control), the redeeming member is essentially shifting some of the costs of converting securities into cash to the Fund's other holders. Strike that: the redeeming member would be shifting such costs to other holders if the TIFF fund in question did not levy an exit charge aimed at mitigating this harm. Needless to say, a similar problem arises with respect to purchases of Fund shares, which trigger trading whose costs (measurable or otherwise) often do not get reflected in the stated net asset value of a Fund's shares until days after the member's purchase has been recorded in the Fund's capital accounts. Why? Because in an effort to mitigate "market impact" TIFF's outside managers do not always put incoming cash to work immediately.

Believe It or Not

It may surprise TIFF members who've complained about the transactions charges we've been discussing to learn that such charges don't cover staff's best guesses respecting the true costs of trading incurred by the TIFF funds in question:

TIFF Fund*	Estimated One-Way Trading Costs	Entry/ Exit Fee**

Multi-Asset Fund	0.60%	0.50%***
International Equity Fund	0.95%	0.75%
US Equity Fund	0.45%	0.25%

* As noted in footnote 1, the TIFF Bond Fund and TIFF Short-Term Fund do not charge entry or exit fees.
** The fees in question apply only to transactions that trigger trading within each fund. Accordingly, such fees are waived on dividend and capital gains distributions (as well as the reinvestment of same) and on in-kind contributions and redemptions. The latter are permitted by the prospectus but are exceedingly rare.
*** At their December 2000 meeting, TIFF's mutual fund directors approved staff's recommendation to reduce MAF entry and exit fees from 0.75% to 0.50%, effective December 15, 2000.

Why doesn't TIFF raise the transactions charges shown above to cover the true costs of trading? Because we'd rather undershoot than overshoot, mindful that trading costs continue to decline. Also, strange as it may seem, we don't really enjoy being harangued about such charges, and we're certain that complaints about them would become more numerous and strident if we boosted them to levels consistent with each fund's true trading costs.

Endnote

1. This essay focuses on TIFF's equity-oriented mutual funds (of which there are three at present; see table above) because the dominance of highly liquid government debt in bond markets makes trading costs almost immaterial with respect to investment grade debt portfolios of the sort administered by TIFF. This explains why the TIFF Government Bond and Short-Term Funds do not assess entry and exit fees, whereas our other funds (which invest primarily or exclusively in stocks) do levy such charges.

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