Study Shows Investors Pass Over Expense Ratios

What do your mutual funds and a pack of cigarettes have in common? According to a recent study, it's more than just toxic assets. Both, it turns out, come labeled with important information that most buyers choose to ignore.

Like the tobacco industry, mutual funds have a number of regulations governing their ads. But just as many smokers pass over the warnings on their favorite cigarettes, investors tend to overlook readily displayed information about costs. In particular, researchers say investors pay little attention to the expense ratios that mutual funds are required to display on certain advertisements. Given that even tiny differences in ratios can either save or cost investors thousands of dollars, the study offers important insight into consumer behavior.

Currently, if funds display past fund performance in their ads, the Financial Industry Regulatory Authority mandates that they also feature expense ratios in an equally prominent position.

But the study, conducted by professors from Furman and Radford universities, showed that participants focused almost exclusively on funds' past returns. "We believe that the return paradigm . . . is so overwhelmingly strong that they're basically ignoring the other pertinent information in the ad," says researcher Thomas Smythe, an associate business and accounting professor at Furman.

The advertising rule is in place because expense ratios determine what portion of a fund's total returns investors can actually take to the bank. That's because operating costs are taken out of returns before profits are passed along to shareholders.

Take, for instance, the fund Pimco Total Return fund. Its institutional shares have an expense ratio of .45 percent, while the equivalent number for its class C shares is 1.65 percent. According to Morningstar, if you bought $10,000 in institutional shares in September 1994 (roughly 15 years ago), your investment would have been worth $30,334 at the end of August 2009. If you put the same amount into C shares, you'd have had $25,301.

To test the effectiveness of FINRA's rule, researchers showed fake advertisements to 33 study participants. Each advertisement contained the fund's expense ratio and information about its past returns. When participants, who had varying degrees of financial experience, ranked the funds, they heavily favored strong performers. While some of the highly rated funds had favorable ratios, researchers determined that performance was definitively the controlling variable.

Part of the problem, Smythe says, is that many investors don't understand what expense ratios mean. In fact, when surveyed after making their rankings, most participants faulted the ads for not displaying any information about costs, despite the fact that the numbers were right in front of them.

Even those investors who realize that the numbers contain important information often lack points of comparison. Since expense ratios are small numbers, it's hard to determine what figures are reasonable. One potential fix, Smythe says, would be to require funds to provide benchmark comparisons on their ads. "If you've got some relative context in which to put that information, you might pick up on it," he says.

Another solution would be to nix the rule entirely. Smythe says it's expensive, at least at the margins, for funds to redesign their ads to include cost ratios. "That cost is getting passed along to the investor," he says. "So if you're increasing cost without any benefit, then one possibility is to scrap the requirement," he says. Still, further tests are needed, in part because of this study's small sample size.

But Christine Benz, Morningstar's director of personal finance, isn't surprised by the findings. "Talking about expense ratios tends to just bring yawns to the crowd," she says. "It's hard to get anyone excited about numbers that are seemingly this small."

According to Benz, though, even decimal-point differences are worth noting. While many investors look to total return as their guiding force, Morningstar research indicates that expense ratios are among the best indicators of how well a fund will perform in the future. "And they are a particularly important predictor in some of the lower-returning asset classes like fixed-income funds," says Benz.