Do Mutual Fund Investors Care About Fees?

"Over 80 percent of the group given information on fees still failed to minimize index fund fees."

To what extent do fees affect the choices that investors make regarding mutual funds? How much attention do investors pay to these fees, assuming that they even understand them? What information regarding mutual fund service costs do investors value? Are expensive fees justified in terms of the funds' returns?

These are some of the provocative questions explored in experiments conducted by James Choi, David Laibson, and Brigitte Madrian as reported in Why Does The Law of One Price Fail? An Experiment on Index Mutual Funds (NBER Working Paper No. 12261).

The researchers' principal experiment, conducted in 2005, gave subjects four S&P 500 index fund prospectuses and asked them to allocate $10,000 among these funds. Because these were all invested to equal the behavior of the S&P 500, a wise investor would choose the fund with the lowest fees since that would yield the best performance. After making their allocation decisions, the subjects completed a debriefing questionnaire that asked them to rank the importance of various factors on their investment choices. To create incentives so that the subjects would consider their allocation decisions carefully, the researchers randomly selected subjects to receive the next year's return from their hypothetical portfolio (if that return was positive).

The experiment divided participants into three groups. The control group has only a prospectus of each of the funds. Subjects in the second group received information on the funds' fees while the third group received information on the funds' past returns.

The subjects in the experiment were a mix of Harvard and University of Pennsylvania undergraduates and University of Pennsylvania MBA students. The undergraduates and MBAs reported average combined SAT scores in the 99th and 98th percentiles, respectively, suggesting that these subjects are better equipped than most investors to make these types of investment decisions.

Subjects in the control group - those who received only the four mutual fund prospectuses - chose portfolios with an average fee that was only slightly below the average fee of the four index funds. Over 95 percent of control group subjects failed to minimize fees by allocating all of their money to the lowest-cost fund.

Giving subjects a fee summary sheet - in addition to the four prospectuses - caused investments to shift toward lower-cost index funds relative to the choices of the control subjects who received only the fund prospectuses. However, over 80 percent of the group given information on fees still failed to minimize index fund fees.

In the third group, the researchers gave subjects the four mutual fund prospectuses and the returns summary sheet, which highlighted each fund's annualized returns since inception. Because the funds were started on different dates, "annualized returns since inception" largely reflects the historical performance of the S&P 500 since a fund's inception date and thus is not informative in predicting the four funds' future returns. By design, the researchers selected funds for the experiment such that annualized returns since inception were positively correlated with fees. Chasing returns since inception thus would lower expected future returns. The researchers observed this returns-chasing behavior: portfolio fees are higher in the group given information on past returns since inception than in the control group.

Choi, Laibson, and Madrian find that many of the subjects did not realize the importance of fees in making their allocation decision. Even when subjects did realize the importance of fees - ranking fees as important in the debriefing questionnaire - they often were not able to identify the fee information in the prospectus or were nonetheless swayed by other uninformative measures, such as returns since inception. When the fee information was made transparent by giving subjects a fee summary sheet, subjects still did not invest in the lowest-fee fund. The researchers find similar results when subjects were given a returns-summary sheet. In this group, subjects chased the salient, irrelevant past returns and lowered their future expected returns.

Interestingly, the researchers find that those subjects who chose higher-fee portfolios seemed to know that they were making a mistake. In the debriefing survey, these subjects were less confident that they were making the best allocation decision.

Choi, Laibson, and Madrian also briefly discuss a second experiment similar to the first experiment except that the four funds considered were actively managed small cap funds. In this experiment, there was only a fees-summary treatment condition and a control condition. The researchers find similar results to the first experiment: providing the fees-summary sheet decreased the average fees paid, but subjects still paid fees far above the minimum.

Choi, Laibson, and Madrian believe that their findings have several implications. First, they say, it is wrong to assume that investors are sufficiently alert to the significance of fund fees. The researchers suggest that it may be useful to provide incentives for intermediaries, such as 401(k) plan providers and state 529 college-savings plan administrators, to respond to mutual fund fees, because many individuals are not doing so themselves. Further, it seems that the current prominent disclosure of historical returns information may inhibit wise portfolio choice.

Choi, Laibson, and Madrian say that what matters is not only what information must be disclosed, but also how it is disclosed. Current Security and Exchange Commission regulations on fee disclosure, they say, may not be having the desired result. If important information, such as a fund's expense ratio and load, were required to be more transparent rather than buried in a prospectus, the researchers believe that there would be an aggregate reallocation of investment in low-cost funds. This, they add, would likely provide an impetus for high-fee funds to lower their fees

-- Matt Nesvisky