Mutual funds: The less you understand, the more you pay

Posted by TEBI on March 7, 2022

Mutual funds: The less you understand, the more you pay





Index funds are meant to be simple. That is a large part of their appeal.

If you are just buying the index, you should know exactly what you are getting. It should be straightforward, uncomplicated and cheap.

Unfortunately, the mutual fund industry has a long history of being none of those things. Some of it is self-serving. Some of it has been due to regulation. But asset managers sadly tend towards making things unnecessarily complex. And expensive.

Index funds, it turns out, are not immune from this.


The link

A recent research paper by Ed deHaan from the Foster School of Business at the University of Washington, together with colleagues from his own school, MIT and the University of Pennsylvania brought this to the fore.

In the study titled “Obfuscation in Mutual Funds”, DeHaan and his team wanted to determine whether there was a link between complexity in mutual fund documents and the fees those funds charged.

“Mutual funds hold 32% of the US equity market and comprise 58% of retirement savings, yet retail investors consistently make poor choices when selecting funds,” the authors wrote. “Theory suggests that poor choices are partially due to mutual fund managers creating unnecessarily complex disclosures and fee structures to keep investors uninformed and obfuscate poor performance.”

Since it would be quite difficult to measure this among active managers, where returns can range so widely, the researchers only looked at S&P 500 index trackers. As the performance of these funds before fees should be similar, this allowed them to test whether there was any correlation between complexity in fund documents and poorer performance due to higher fees.


The correlation

What they found is telling: funds have that more complexity in their material also have higher fees, and therefore worse returns.

“These findings are consistent with fund managers using both narrative and structural complexity to obfuscate high fees,” DeHaan and his colleagues wrote.

They also found an interesting link to the way products are marketed.

“We also examine the role of marketing, which we expect to be more effective when investors are uninformed. We find positive associations between marketing efforts and both narrative complexity and structural complexity, consistent with aggressive marketing being a complementary strategy for high-fee funds.”

In other words, the more a fund company markets its products, the more likely those are to have complex literature and higher fees.


The cost

It is important to point out that, as the authors acknowledge, this doesn’t mean that asset managers deliberately create this complexity to hide higher fees. It may simply be that this kind of behaviour evolves over time.

Nevertheless, the costs to investors are significant. The authors state that: “retail investors paid an extra $358 million in 2017 alone by holding high-fee versions of S&P 500 index funds”.

One specific example they give is that Schwab’s S&P 500 fund charged a fee of 0.02% in 2019. It had no upfront fees and no different fee classes.

Deutsche’s S&P 500 index fund, by contrast, could charge up to 5.06%. It had five different fee classes, and upfront fees as high as 4.5%.

And so, despite both funds earning almost identical returns before fees, the outcomes for investors could be substantially different.


The complexity

What is striking is how different the two prospectus documents for these funds look.

As its investment objective, the Schwab fund states: “The fund’s goal is to track the total return of the S&P 500 Index.”

The Deutsche fund’s investment objective reads: “The fund seeks to provide investment results that, before expenses, correspond to the total return of the common stocks publicly traded in the United States, as represented by the Standard & Poor’s 500 Composite Stock Price Index (S&P 500 Index). The fund invests for capital appreciation, not income; any dividend and interest income is incidental to the pursuit of its objective.”

This is just one example, but it highlights an important truth for investors: the less you understand about a fund, the more you are likely to end up paying for it. This is as true for index funds as it is for actively-managed ones.

Fortunately, once you know about it, it’s an easy trap to avoid. If you don’t understand what a fund’s investment strategy is and exactly what fee you will be paying, look elsewhere. By doing so, you will probably save yourself a lot of money.


One of South Africa’s most respected financial journalists, PATRICK CAIRNS is a trusted commentator on the world of investments and the quirks of behavioural finance. Over more than a decade he has built a reputation for keeping the industry honest, and putting the interests of investors first.
Here are some more articles by Patrick Cairns:

Three steps to breaking the money shame spiral

Three reasons not to wait to talk to your kids about money

Do men and women invest differently?



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