Lisa Kramer is a professor of finance at the University of Toronto.
Would you rather pay a 1-per-cent fee or a $1,000 fee on $100,000 invested in a mutual fund? Before you congratulate yourself for noticing that 1 per cent and $1,000 amount to the same fee in this example, I ought to tell you that you may be making a related mistake in your own investment accounts that could be costing you buckets of money.
To demonstrate the issue, I ran a brief survey, asking 100 people one of two questions. For half the group, I described a typical mutual fund and asked, “How likely would you be to put your savings in this mutual fund if it charges a 1-per-cent fee on a given level of investment?” And for the other half, all details were the same except the fee was expressed in dollars instead of percentage terms.
The difference shouldn’t matter, right? Not so fast.
With the fees expressed in dollars, participants were about equally likely to say they would or wouldn’t invest in the fund. However, with the fees expressed in percentage terms, participants were almost twice as likely to say they would invest in the fund, suggesting they were markedly less put off by fees than the group shown fees in dollars.
Now converting percentages to dollars isn’t rocket science, but the human brain has a tendency to take mental shortcuts (a phenomenon highlighted in Nobel Laureate Daniel Kahneman’s bestselling book Thinking Fast and Slow), causing investors to inaccurately gauge the pocket-book impact of fees when expressed in terms other than dollars and cents.
Opining on regulatory matters in the asset management arena surely won’t garner me any cocktail party invitations, but hear me out.
Last year, a regulatory change called CRM2 (for client relationship model phase 2) came into effect in Canada, requiring that certain fees paid by investors would have to be expressed more clearly, including trailer fees (which are fees a fund manager pays to a salesperson, ultimately passing the cost along to the investor). Until CRM2, many investors were unaware they were paying these fees. But now investors have easy access to the exact dollar amount they pay in these fees for some investment funds they hold, permitting better-informed decisions.
Unfortunately, many other fees faced by investors continue to be opaque.
The Mutual Fund Dealers Association of Canada announced recently that it seeks to promote transparency around an even broader set of fees and to a wider set of investment products than are currently covered.
Improved fee disclosure can’t come too soon. A variety of reports show that Canadian investors pay some of the highest fees in the world, collectively costing them billions of dollars in extra fees each year. Fortunately, research suggests that a bit of sunlight, plus a dash of behavioural economics, may help address that problem.
First, a study performed by Britain’s Financial Conduct Authority tested four different interventions, or nudges, for illuminating fees: a simple warning telling investors that fees can affect returns, a comparison chart that compared the fund’s fee with market average fees, a graph demonstrating the impact of the fund’s fees on investment performance over time, and a combination of several interventions. All of these treatments increased the rate at which participants chose an otherwise-identical fund with lower fees (which is good, since higher fees don’t translate into better fund performance).
Second, a recent working paper by Professor Sitikantha Parida of Clark University examined a past change mandated by the U.S. Securities and Exchange Commission that required mutual fund fees to be disclosed in dollars rather than percentages. Following the disclosure improvement, average fees charged by affected funds eventually dropped by 27 basis points. And investors became more likely to choose funds with relatively lower fees.
To be clear, this is not a rant against the legitimacy of fund fees. Even the passive management of funds comes with costs, and those costs should be borne by investors. The point is that the investors ought to be able to make decisions with the benefit of clear information. Regulators have cottoned on to the fact that behavioural economics offers tools that can help immensely in the design of industry rules. Continued use of such tools will promote better investor decisions.