“Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows” Barber, Odean & Zheng (2003)
This paper presents some evidence toward my hypotheses for why investors overpay for mutual funds. Briefly, investors might be so prone to overpaying because fund charges are described in percentages – e.g. 1% of assets per year – and are subtracted from the fund’s gross return, so they are only indirectly “paid” for. These costs are not salient, unlike other fund expenses which this paper shows investors are sensitive towards . . .
The authors split fund fees into yearly management fees and front-end loads – paid at the point of purchase, and also described in a percentage of assets. The authors hypothesise that front-end loads are a more salient cost than the yearly fee, since their cost can be deduced on the first brokerage statement, while the yearly fee’s impact is swamped by fund volatility. Front-end fees are easier to mentally represent in terms of their actual costs.
Their results should that although investors are cost-sensitive to front-end loads, there is actually a positive relationship between the yearly fee and fund flows. It turns out that this relationship is driven by funds increasing their fees to finance marketing campaigns, with the net result being an increase of net flows to the fund. New investors attracted by the marketing campaign outweigh investors who leave because of the higher fee (and people not joining because the fee is now bigger). Furthermore, experienced investors are less likely to purchase funds with a front-end load but this does not translate to yearly fees.
An additional study on fund supermarkets, which offer a range of mutual funds from different companies, confirms the results on the differential impact of up-front and yearly fees. The funds without an up-front fee tend to have a higher yearly fee, and actually grow faster than the funds with an up-front fee. These fees are usually fairly small, so rational investors with long time horizons should place a much greater weight on the percentage fee, but they don’t.
A worrying conclusion from the paper’s conclusion is that mutual funds have gradually shifted away from using front-end loads and towards using higher yearly fees. They seem to be learning the way to frame their expenses that their customers will be least cost-sensitive to. A dark nudge if ever I’ve seen one.