Average Investor Does Not Understand Importance of Mutual Fund Fees in Investment Decisions Finds Yale School of Management Study

New Haven, Conn., April 11, 2006—A study that examines the demand for high-fee mutual funds finds that many investors do not realize that fund fees are important for making investment decisions, are swayed by irrelevant prospectus information, and often buy high-cost funds even though they sense they may be making a mistake.

The study was conducted by James Choi of the Yale School of Management, David Laibson of Harvard University, and Brigitte Madrian of Wharton using MBA and undergraduate students from Ivy League universities as subjects. The students, who had difficulty navigating fees, were found to have a higher degree of financial literacy than the typical American investor.

“Our research adds to the growing body of evidence that shows that the average investor is not well equipped to manage their investment allocations,” said Professor Choi, a fellow at the Yale School of Management’s Center for Customer Insights and International Center for Finance, institutes that collaborate on investor behavior research.

In an experiment that manipulated the transparency of fund fees, subjects were asked to allocate $10,000 across four front-load S&P 500 index funds. One group received only the prospectuses for the four funds; another received the prospectuses and a one-page summary sheet outlining the fees of each fund. In the prospectus-only group, only 19 percent of MBA and 10 percent of college students minimized fees by allocating all of the money to the cheapest fund. The fee sheet caused investments to shift away from high-fee funds, but more than 80 percent still failed to invest everything in the lowest fee fund. 

When asked to rank the factors that were most important in allocating their portfolio, the MBAs identified fees as most important; college students ranked fees eighth in importance.

“The results imply that many investors don’t understand that mutual fund fees are important and therefore don’t search for the fee information in the prospectus,” said Choi. “Those who claim to understand the importance of fees often can’t accurately identify the fee information in the prospectus or may not know how to use it.”

While investors may ignore important fees, they do give weight to irrelevant information. Subjects who were given the four prospectuses and a sheet outlining the annualized returns since inception for each fund chased these historical returns. This information should be irrelevant because the inception date of each fund differed, so variation in returns since inception is driven almost entirely by how the S&P 500 did during the fund’s lifetime.

Investors in high-cost funds do recognize that they may be making a mistake. Subjects who paid the highest fees reported having less confidence that they were making the best portfolio allocations, a higher likelihood of changing their portfolio in response to professional investment advice, and less general investment knowledge.

The results have important public policy implications say the researchers.

“If many investors are not paying attention to mutual fund fees, it may be important to create incentives for intermediaries like 401(k) and 529 college-savings administrators to pay attention for them,” said Choi. “Policymakers should also consider not only what information to disclose, but also how it is disclosed. If important information such as a fund’s fees were required to be transparent rather than being buried in a long prospectus, investors may be more likely to reallocate investments to lower cost funds. This would generate pressure for high-fee funds to lower their fees.”