Obfuscation in Mutual Funds

Chloe L. Xie is Assistant Professor of Accounting at MIT Sloan School of Management. This post is based on a recent paper, forthcoming in the Journal of Accounting and Economics, by Ms. Xie; Ed deHaan, Associate Professor of Accounting at the University of Washington Foster School of Business; Yang Song, Assistant Professor of Finance at the University of Washington Foster School of Business; and Christina Zhu, Assistant Professor of Accounting at the Wharton School of the University of Pennsylvania. Related research from the Program on Corporate Governance includes Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); and The Specter of the Giant Three by Lucian Bebchuk and Scott Hirst (discussed on the Forum here).

Over 9,000 mutual funds, holding $21.3 trillion in assets, were traded on U.S. exchanges during 2019. Mutual funds hold 32% of the total U.S. equity market value and comprise 58% of retirement savings (Investment Company Institute 2020). Despite the popularity of mutual funds, many studies find that they underperform and that retail investors consistently make poor choices when selecting funds. For example, retail investors could have saved $358M in 2017 alone by switching from high-fee to low-fee versions of S&P 500 mutual funds with nearly identical pre-expense returns. Investor advocates argue that poor mutual fund choices are due in part to complex financial disclosures and fee structures that make it difficult to compare funds. In a paper forthcoming in the Journal of Accounting and Economics, we investigate whether mutual funds create unnecessarily complex disclosures and fee structures to obfuscate high fees.

Academic theory suggests high-fee index funds create unnecessarily complex disclosures and fee structures so that investors find it difficult to learn from disclosures and make informed decisions (Carlin 2009). But a challenge in investigating this question is controlling for variation in non-discretionary complexity caused by differences across funds.

We mitigate this issue by examining S&P 500 index funds, which have largely homogeneous gross investment returns and risks but charge different fees. Despite earning nearly identical pre-expense gross returns, S&P 500 funds charge widely different fees for doing so. For example, Schwab’s S&P 500 fund charged 2 basis points (bps) in 2019 while Deutsche’s charged up to 508 bps, despite earning nearly identical pre-expense returns (31.46% and 31.47%).

We document that high fee-funds increase two types of complexity to keep investors uninformed. Funds increase “narrative complexity” by using unnecessarily bad writing to make disclosures less readable. The SEC has repeatedly expressed concerns about the narrative complexity of mutual fund disclosures, but to date it has received little academic attention. Continuing the example, Schwab discloses its objective using 14 words in its prospectus: “The fund’s goal is to track the total return of the S&P 500 Index.” In contrast, Deutsche uses 60 words to describe its objective. We examine narrative complexity within funds’ prospectuses, and especially within summary prospectuses, which research finds are a common source of information for retail investors. We measure narrative complexity based on guidance from the SEC about what make documents difficult to read: prospectus length; number of words per sentence; repeating blocks of text; and the number of separate funds discussed in a single document. We find that all four measures of readability are worse for high-fee funds.

Funds also increase “structural complexity” by creating complex intra-fund structures and fee schedules that make it hard for investors to compare funds and identify the fees they must pay. For example, Schwab has one share class, while Deutsche has five different classes with different fee structures. We measure structural complexity based on the fund’s number of share classes and types and tiers of fees. Consistent with strategic obfuscation, we find that the high-fee S&P 500 mutual funds have more fund classes and more types and tiers of fees that are likely difficult for retail investors to understand. Within a high-fee fund, the cheapest classes charge on average 57 bps more than the most expense classes of low-fee funds.

Many funds belong to families of funds offered by the same parent company. We find evidence that high-fee funds tend to cluster with other high-fee funds by sharing the same parent company. There is a common strategy at the parent company to charge high fees and obfuscate with complexity. Our finding for S&P500 funds generalizes to the parent company of many mutual funds. This suggests that the obfuscation of high fees with complex disclosures and fee structures likely generalize to the broader mutual fund market. The parent companies of high-fee funds do not offer more financial products and tend to offer fewer choices of passive funds compared to the parent companies of low-fee funds.

We also investigate several alternative explanations and find that they do not explain our results. For example, we investigate the effects of two 2009 SEC regulations that were designed to reduce narrative complexity, and we find that funds with the most narratively complex disclosures pre-2009 reduce their narrative complexity more than other funds after the regulations became effective. These results suggest that prospectus complexity is at least partially discretionary. We also find that complexity appears to be a strategy that complements high-fee funds’ marketing efforts (e.g., use of advisors), but high fees do not solely compensate for fund advisors and services.

As discussed in our recent SEC comment letter, our study informs ongoing regulatory efforts to improve mutual fund disclosures. We recommended that regulation do more to limit the degree to which managers may obfuscate fees through complex disclosures and fee structures. We provide tangible policy recommendations: (1) limit and standardize the number and types of fees that funds may charge and (2) standardize the language used in disclosure.

The complete paper is available for download here.

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