What is a dilution adjustment?

In certain circumstances there can be an additional initial or exit cost to investors when buying and selling funds. Rob Morgan explains.

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  1. Rob Morgan

Investing in funds such as unit trusts and OEICs (Open Ended Investment Companies) brings advantages to investors in terms of convenience and diversification. However, it’s important to understand all of the potential costs involved. One less widely understood cost is the dilution adjustment, which applies to OEICs and other ‘single-priced’ funds.

Single or dual priced

Firstly, it’s necessary to clarify what is meant by single priced. Unit Trusts have an 'offer' price, the price at which an investor buys units in a fund, and a 'bid' price – the price at which investors can sell their units in a fund. The difference between the bid and offer prices reflects the bid/offer spread of the underlying investments and the costs incurred in buying or selling them. Unit Trusts are therefore ‘dual priced’.

Single-priced funds are bought or sold by investors at the same price. The fund manager will, however, still be buying or selling the underlying investments on a dual-price basis in the market. This means there will be a difference between the price an investor pays to buy units or receives when selling units in the fund and the price the fund manager has to pay or receives for the underlying investments.

The ‘dilution’ effect

As well as the bid/ offer spread of underlying investments there are also other costs such as broker dealing fees, foreign exchange dealing costs and Stamp Duty Reserve Tax (SDRT) – or any equivalent charge levied in foreign markets. Dilution is the effect all these costs have on the fund when investors purchase or redeem units.

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 value of the fund would be reduced as a result of the costs. To protect existing investors from bearing these costs the fund manager may apply a ‘dilution adjustment’, also known as ‘swing pricing’, which effectively increases the cost of buying or selling.

When do dilution adjustments occur?

Policies among fund managers vary. Most fund managers consider that small amounts of buying or selling activity on a fund will not result in material transaction costs and this can be covered by the fund.

Often, in the case of unit redemptions, there is a sufficient cash balance in the fund to cover pay outs to investors selling their units meaning there is no need to sell any investments and incur additional transaction costs in doing so. For many funds there is often a good balance of sellers and buyers anyway, meaning that dilution adjustments are rarely applied. However, a level of fund inflows or outflows above a certain threshold could trigger the use of a dilution adjustment in any fund that has this policy.

Dilution levy

A dilution adjustment affects any investors who deal on a particular day when there are large inflows or outflows that cause dilution deemed to be significant. A ‘dilution levy’ is slightly different. It only affects the parties who trigger the price movement because their deal is particularly large and creates a significant volume of inflows or outflows. In this situation investors with large deals, or those with smaller deals aggregated by a custodian into a large deal, would be affected by a dilution levy whereas smaller, standalone deals would not.

It is important to note that any dilution adjustment or dilution levy is paid into the fund. The fund management company does not benefit. It is purely to protect existing investors in the fund from bearing the transaction costs of other parties choosing to buy or sell.

Which funds are more likely to apply dilution adjustments?

While it is not possible to predict accurately whether dilution adjustments would occur at any point in time, there are some fund characteristics that make it more likely.

Funds experiencing a large level of net sales or redemptions relative to its size are more likely to impose dilution adjustments, as well as funds where there is a continual decline or increase rather than a balance of sellers and buyers.

Because the cost of dilution is related to the cost of dealing, dilution costs are generally higher for certain types of funds and be more significant when they apply. Examples include smaller companies funds, where the difference between the buying and selling price is high than with larger funds, and emerging markets funds, where broker fees and related dealing costs are generally higher.

Dilution adjustments are also more likely to apply to funds containing illiquid assets – investments that are difficult or costly – to buy and sell readily. For instance, commercial property funds have typically used them extensively when there have been substantial outflows.

Property funds

Property funds can also introduce ‘fair value pricing’ which can deter redeeming investors and may take effect as a dilution adjustment or dilution levy. This means a fund manager makes adjustments to the value of their assets based on their estimates of the current likely values of the fund’s property holdings, if it had to be sold at short notice and potentially not achieve recent valuations.

The primary aim of this is to prevent sellers from receiving too high a value for their shares, which would impact long-term investors in the fund. It also means that when investors want to cash in their investments, fund managers aren’t forced to sell physical property at short notice, which could mean they’re unable to get as high a price as they would if they were able to wait.

This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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