By Heather Bell
Do mutual fund investors really care about fees and expenses?
That's what Yale's James J. Choi and Harvard University's David Laibson and Briggitte C. Madrian teamed up recently to figure out.
The trio delved into investor behaviors and how much investors care about fees and expenses in the working paper titled "Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds."
Hypothetical investors were given $10,000 to invest in four S&P 500 funds with varying fees; to construct the optimal portfolio investors would have to invest 100% in the lowest-fee fund.
So did they? Well... not so much.
First off, let's take a look at the subjects in these experiments, which took place in the rarefied air of upper-echelon academia.
One group was composed entirely of Harvard staff - the vast majority were college graduates, and about 60% had at least some graduate school education. Another group included MBA students from the University of Pennsylvania's Wharton School; the group had an average SAT score of 1453. The final group comprised Harvard undergraduates with an average SAT score of 1499. Those SAT averages are in the top 98th and 99th percentiles, so we're talking about some pretty intelligent people. An assessment of the participants found them to be more financially literate than average.
There were three different scenarios applied to each group. In the control experiment, the participants were given just the prospectuses for four different S&P 500 index mutual funds charging different loads and expense ratios and told to allocate $10,000 among the four funds for maximum returns. The second experiment supplied subjects with the four prospectuses and a sheet that summarized the fees and loads for them so that they did not have to go searching through the prospectuses for them. The third experiment gave the subjects the prospectuses and a sheet summarizing historic annualized returns since inception or over the 10-year period.
Since the Harvard staff segment of the study was done two years after the research conducted with the college and MBA students, the authors of the study added an additional experiment. The subjects in a fourth group of Harvard staff members were given the prospectuses as well as a FAQ sheet explaining exactly what an S&P 500 index mutual fund was. The point of the FAQ sheet was to emphasize that the funds are largely similar products and to see if that might draw investor attention more toward the issue of fees. (It didn't, really.)
In all the experiments, the subjects were paid a flat fee and also incentivized to pick the best portfolio with the possibility of performance-based rewards. At the end of the experiment, each subject filled out a survey that pulled together demographic information, ranked the factors the subjects used to make their decisions, asked how long it took to come to a decision, had subjects rate their confidence level and tested their financial literacy.
Most of the subjects, despite their above-average financial literacy, did not understand the importance of fees. And even when they did, they did not necessarily act on that belief. The MBAs were the only group to rank fees as most important, but they didn't automatically allocate their money to the cheapest funds, even when presented with the fee summary sheet.
However, subjects who were presented with the prospectuses and the fee summary sheet were more likely to invest all of their $10,000 in the fund with the lowest fees.
Among the Harvard staff, about 10% of those given the fee summary sheet put all their money in the lowest-priced fund as opposed to less than 5% of the subjects doing so in each of the other scenarios. None of the college students put all of their money into the lowest-priced fund except a few of the ones who received the fee summary sheet, about 10% of the participants.
Among the MBAs, nearly 20% of the subjects who were given fee summary sheets put all their money into the lowest-cost fund, the highest percentage achieved by any of the three subject groups in any of the experiment permutations. Far less than 10% of the MBA subjects in each of the other two permutations put all of their money into the cheapest fund.
Overall though, when the fee structures were made more transparent, fewer assets were allocated to the funds with the highest costs, and the average amount of fees dropped. The fees fell a whole 5% for the Harvard staff members, and 1% for the MBA students. The decline for the college students was statistically insignificant.
Historical returns were a factor that was also shown to have an effect on how subjects made their decisions once they were singled out. When given a sheet summarizing the historical returns in the prospectuses, both student groups allocated more money to the funds with the best returns since inception - although these dates were not directly comparable.
The Harvard staff group did not follow this trend, but the evidence indicates that they were already considering returns and searching for them in the prospectuses rather than that they ignored them. When Harvard staff members were provided with the list of FAQs explaining what an S&P 500 index mutual fund was, the portfolio fees declined, but not in a way that would be considered very statistically significant.
Despite failing to put all their money into the cheapest fund, there is a glimmer of hope with regard to investor understanding. Those who paid the highest fees were also the least confident about their choices, so they had at least an inkling that they might be on the wrong track. The authors suggest that the failure to invest entirely in the lowest-cost fund - instead investing a little in more than one of the offered funds - might indicate that the subjects do not fully understand the concept of portfolio diversification.
This is a highly readable and sometimes funny research article. (See the footnotes on page 7, in particular, where a Morgan Stanley representative actively discourages a caller from buying the firm's S&P 500 fund.) Most importantly, it offers a look into how investors think and the importance (or lack thereof) that they place on fees - and where education efforts should be focused in the future.
BONUS: Yale professor Robert Shiller is one of the developers of the S&P/Case-Shiller Home Price indexes. A paper he presented last year, "Derivatives Markets for Home Prices," is available on the SSRN site here. In it, he discusses the history of the development of real estate derivatives markets and the obstacles to their acceptance and growth.