An Experiment on Mutual Fund Fees in Retirement Investing

The following post comes to us from Jill E. Fisch, Professor of Law at the University of Pennsylvania Law School, and Tess Wilkinson-Ryan of the University of Pennsylvania Law School.

In our paper, An Experiment on Mutual Fund Fees in Retirement Investing, we report the results of a new experiment studying the impact of mutual fund fees on consumer investment decisions. The importance of fees to overall investor returns, especially in the context of long-term investing like retirement accounts, is frequently overlooked. Morningstar’s Director of Mutual Fund Research recently observed, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision.” But there is evidence that many investors are paying high fees. One study estimates that in 2007 alone, retail investors paid $206 million more in S&P index fund expenses than they would have paid had all investments been in the lowest-fee funds.

Why are investors willing to pay high fees? Are existing fee levels the result of robust market competition or do market failures or investor biases limit market discipline? In his recent Jones v. Harris opinion, Judge Easterbrook took the efficient market position, concluding that market forces will lead investors to reject funds that charge excessive fees in favor of more fairly-priced alternatives. Under this view, investors will only pay higher fees when those fees are justified. Judge Posner countered, in dissent, with an empirical question: do high fees really affect investor behavior? A growing collection of evidence suggests that Judge Posner’s skepticism is well-founded; in the market for mutual funds, uninformed investors do not appear able or willing to distinguish between cheap and expensive funds.

One of the challenges in evaluating investor responses to fees is to understand why investors so frequently overlook fee information, and what kinds of interventions might make fees more salient. Our study tested the prediction that people ignore fee information because fees appear to be so inconsequential, but that they will focus on fees when they learn that fees have large effects on returns. We instructed subjects to choose hypothetical retirement portfolios from ten fictionalized funds. We provided subjects with simplified fee information for each fund in a form that was readily comparable, as well as information about fund holdings, risk, and past performance. Subjects were paid based on the simulated 30-year performance of their portfolio. Critically, one group of subjects received a special instruction emphasizing the importance of fees to overall fund returns and a control group did not receive this instruction.

We used two subject pools, one comprised mostly of undergraduates at the University of Pennsylvania and the other from a panel of online survey respondents sourced through Amazon Mechanical Turk. Our study design permitted us to evaluate the effects of the Fee instruction in three ways. First, by recording where and how often subjects clicked, we could compare the information that subjects searched for. Second, we collected information on subjects’ attitudes and beliefs, enabling us to see whether the fee instruction changed those beliefs. Third, we could compare the subjects’ allocations among different investment options with different fees.

Our results showed that the fee instruction had a statistically significant effect on all three aspects of our subjects’ behavior. Subjects who received the fee instruction were more likely to look for information about fund fees. Subjects who received the fee instruction were more likely to believe that fund fees affect returns and that fee levels were an important criterion in selecting among investment alternatives. Finally, subjects who received the fee instruction allocated their investment portfolio differently from those in the control group – distinguishing more between high- and low-fee funds and choosing portfolios with lower overall fees.

Many studies have identified biases or mistakes in consumers’ real world investment decisions. The regulatory changes that have increased individual consumer responsibility for retirement savings and investment choices magnify the consequences of these mistakes. The extent to which disclosures, investor education, or other strategies can address these mistakes is a critical policy concern. Indeed, Section 917 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires the Securities & Exchange Commission to conduct a study of investor financial literacy with the specific regulatory objective of improving disclosures necessary for retail investors to make informed financial decisions. The results of this study support some tentative optimism about the efficacy of educating investors about the importance of fees. Advice about the real impact of fees on returns appears to constitute new information for at least some and maybe many investors. Furthermore, it is information they can use. When fee information is presented simply and transparently, educating investors about the importance of fees updates their investment beliefs, motivates more thorough research into their options, and yields higher-value investment choices.

The full paper is available for download here.

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