Beyond The Abstract: Investors Are Not Efficient Shoppers

April 28, 2008

A recent paper finds that investors consistently fail to consider fees and expenses when selecting comparable funds.


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.

Round Four 

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.


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