Dilution Levy

To our clients*,

Our Authorised Corporate Director (“ACD”), Maitland Institutional Services Ltd., applied a dilution levy across our UCITS OEIC Funds from Monday 23rd June, 2014. The dilution levy is a charge in favour of Fund holders to compensate for dilution costs. ‘Dilution’ costs are the costs of dealing (including spreads, FX, stamp duty and broker costs etc.) when clients purchase or redeem investments, which therefore reduce or ‘dilute’ the value of the Fund. These costs can be small but are compounded over time when charged to the Fund (and therefore act as a drag on unit holder performance). There are a number of ways to account for these costs. They can either:

a) be charged to the Fund (and therefore to existing investors who have not created these costs) diluting the NAV of Fund units OR

b) be charged directly to the buyers or sellers who have generated the costs.

The intention is that long-term investors in the Fund are not penalised for other investor’s daily trading costs. This is levied by the ACD and Somerset retains none of the levy. It is paid directly into the Fund.

* of our UK UCITS Funds


1) What is “dilution”?

Dilution refers to the effect that investors have on a Fund when they purchase or redeem units of a Fund. When Fund units are created or redeemed the value of the Fund is reduced because the Fund incurs transaction costs in order to create or redeem a unit. The costs incurred include (but are not limited to): broker dealing fees to purchase or sell shares, foreign exchange dealing costs, the spread between the bid and ask price of the underlying securities (which is not reflected in the price of an open ended investment company priced with a single price) and Stamp Duty Reserve Tax (SDRT) (or equivalent charge levied in foreign markets). When these costs are spread across the existing investors of the Fund (who did not participate in the purchase or redemption of units), dilution occurs: the unit NAV of the Fund will be reduced as a result of the costs. Dilution is therefore a cost borne by existing investors, created by entrance and exit of other investors. If this sounds unfair, please read on to point 2).

Because the cost of dilution is all related to the cost of share dealing, dilution costs are generally higher for Emerging Markets Funds where broker fees and related dealing costs are generally higher.

2) What is a dilution levy?

A dilution levy is collected by the ACD [Fund Administrator] to cover the dilution costs. It is collected from entering or exiting investors of the Fund so that dilution does not occur.

Up until this change on 23rd June for Somerset Funds, although there are dealing costs for all purchases or redemptions, the ACD only charges a levy to compensate for this cost when deals on a specific day account for over 5% of the Fund’s NAV. This is despite the fact that smaller transactions also incur dealing costs. All investments need to be converted into the local currencies of the additional stock purchased, a broker will need to be used and there will always be spread costs.

3) Why am I being charged another fee?

A dilution levy is not a “fee”. It is not a charge levied by a Fund manager from its clients. It is a charge that is paid into the Fund, to the Fund holders. The costs which this fee offsets were in reality already being paid by the Fund (by current investors in the Fund).

4) Is this an entry or exit fee by another name?

No, a dilution levy is not an entry fee or an exit fee. An entry or exit fee is a fee charged by the manager of a Fund. Fund investors would pay an exit fee directly to a management company. Somerset does not charge exit fees on any of its Funds. A dilution levy is charged by the Fund. Fund investors pay this fee to the Fund (to other Fund unit holders). The levy directly benefits unit holders. It does not benefit the management company.

5) If it is only a small amount why can the Fund not bear the costs?

These costs are small but are compounded over time when charged to the Fund and can therefore be a drag on performance. In addition, and perhaps more importantly, we believe it is fair to charge these costs to the buyers and sellers of Fund units who have created them rather than penalise holders of the Fund who have not created the additional costs.

6) Who is it paid to?

This is collected by the ACD and Somerset retains none of the levy. It is paid directly into the Fund.

7) What do other Firms do?

Firms choose to charge this fee in a number of different ways.

In some cases, dual pricing (bid/offer or swing pricing) is used. This should have the same result, but uses a different mechanism, to ensure Funds do not bear these trading costs. In other cases, only larger transactions are charged dilution. This was formerly our approach. The reason for our change is motivated by our focus on fairness as referred to in question 1 and 3. This is a fairer approach because it takes into account the fixed costs of smaller transactions.

Some firms charge no dilution levy at all and this cost is therefore borne by investors in the Fund. The key point here is: if you invest in a Fund which does not charge dilution, you will be subsidising other investor’s trading costs for as long as you hold the Fund.

8) Who sets the Levy?

The dilution levy is set and calculated by the ACD based on the 3 main costs referred to above (spread, broker and FX costs) as well as any other cost the ACD considers appropriate. This levy is higher for the Small Cap Fund than the Large Cap Fund because Small Cap stocks are generally less liquid and therefore the spread and broker costs for these stocks are consequently higher.

9) How much is it?

The dilution levy for the Global EM (Large Cap) Fund will be 30bps, for the EM Dividend Growth Fund it will be 40bps and for the Small Cap Fund this will be 50bps.

10) Will the levy be reviewed?

Yes, it is possible that the dilution levy could change in the future as it is based on the dilution costs. If, for example, these costs fell the ACD would be able to pass this reduction in costs on to new investors through lower dilution levies. The levy will be reviewed by Phoenix Fund Services, the ACD, on an annual basis.

11) Why is it better in the long run?

It is better for the unit holders in the long run because they do not have to subsidise the trading costs of other investors coming into or going out of the Fund.

12) Why is Somerset doing this?

This is being applied by the ACD and not Somerset. However, the reason for the alteration to the current practice is due to a desire to make the current system fairer in repatriating the costs of trading back to the creators of these costs. It is an extension of the current practice of charging a dilution levy on large inflows or outflows because every transaction creates costs for the Fund.

13) Why is it applied to inflows and outflows?

It is only right that it is applied to both because both transactions create dilution costs.

 

 

15th May 2014

 

Dear Investor,

The decision to introduce the dilution levy on all inflows and outflows to our OEICs has been taken after considerable discussion with our Fund Managers, clients, the ACD and other stakeholders. This has not been arrived at in a hurried fashion or with the intention of trying to make life in any way more difficult for our investors. We are well aware that this represents a change for many of our unit holders and we sincerely hope that you will see this as the most effective way to fairly distribute transaction costs.

Please do not hesitate to contact me, Oliver Crawley, Louise Parsons, our ACD or any member of our team should you wish to discuss any aspect of these changes. We trust that over time our move will be seen as both forward-thinking and, ultimately, industry best practice as other firms conform to this standard.

We hope this demonstrates our endeavour to focus on fairness, clarity and putting consumers first and we thank you for participating in these changes with us.

Dominic Johnson, CEO