Investing wisdom sometimes comes from unlikely sources. Tess Wilkinson-Ryan and Jill Fisch are both law professors at the University of Pennsylvania Law School. Their recently published paper, An Experiment on Mutual Fund Fees in Retirement Investing, attempts to answer a vexing question: Why do investors ignore the impact of fund fees when making investment decisions?
With the decline of defined-benefit plans and the rise of 401(k) plans, investment decisions are being made more by individuals and less by professional investment managers. The SEC requires that investors in mutual funds be given a staggering amount of information. Unfortunately, many investors are confused and overwhelmed. This is one reason why the authors of this study accurately refer to “the phenomenon of systematic under-attention to mutual fund fees”.
This is a “phenomenon” because, as the study notes, everyone from the director of mutual fund research at Morningstar to former SEC Chair Arthur Levitt agrees that the management fees charged by mutual funds (expressed as expense ratios) can dramatically affect the returns of the fund.
Expense ratios are expressed as a percentage of assets (as low as 0.1 percent up to 2.5 percent) which makes them seem less consequential. This is misleading. An investment of $10,000 with an average annualized gain of 10 percent would grow to $152,203 if the fund had an expense ratio of 0.5 percent. If the expense ratio was 1 percent, the fund would be worth $132,677—a difference of $41,817.
The study found that investors routinely underestimate the effect of fees on their returns. In a series of experiments, the authors were able to change this behavior by explicitly explaining to the subjects the importance of fees. This information caused those in the study to incorporate fee information into their investment choices. The study concludes that presenting fee information “simply and transparently” and educating investors about the impact of fees has the desired effect of helping investors make decisions likely to yield higher returns.
The typical expense ratio for an actively managed fund (where the fund manager attempts to beat a designated benchmark, like the S&P 500 index) is 1.5 percent. Compare this cost to the typical index fund (where the fund manager attempts to replicate the performance of an index, minus fees) cost of approximately 0.25 percent. If you pay attention to the conclusion in this study, you would select index funds over comparable actively-managed funds, based on the difference in cost.
Is this analysis too simplistic? Not according to Standard & Poors. It compares the performance of actively-managed funds to index funds in a scorecard published twice a year. At the end of 2011, it found the majority of active stock and bond managers underperformed comparable benchmark indexes over a five-year horizon.
Investing does not have to be complex. If you focus on fees and purchase a globally diversified portfolio of low management fee stock and bond index funds in an asset allocation suitable for you, you will have made a decision likely to improve your returns. In stark contrast, owning actively managed mutual funds is likely to lessen your returns and make your retirement goals more difficult to attain.
Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.
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