Costly Funds Are Today’s Snake Oil

New research reveals that investors believe high-price mutual funds can produce investment miracles.

Few mutual fund investors would ever equate themselves with the gullible folks that bought Clark Stanley’s snake oil liniment at county fairs back in the 1700s, but sadly similarities exist.

The popular Mr. Stanley’s liniment promised arthritis sufferers miraculous relief from their pain via a simple application of his specially formulated Chinese Water Snake oil. People lined up in droves with open wallets in hand. Now centuries later, we snicker in disbelief that the naive and uneducated were actually suckered into such quackery. New research, however, suggest that buyers of high-price mutual funds may be suffering from a similar psychology.

Just this week, Tess Wilkinson-Ryan and Jill Fisch of the University of Pennsylvania Law School released compelling research revealing the psychological dynamics surrounding investors’ selection of high-price mutual funds over lower priced index funds.

Wilkinson-Ryan and Fisch were curious about the continued illogical behavior of investors in the mutual fund marketplace. Despite a spate of research demonstrating the deleterious effects of mutual fund fees, in lemming-like fashion, investors continue to pile off the cliff of high-price mutual fund underperformance. They wanted to know why.

Their study begins with a helpful review of past research. According to the work of Cooper, Halling and Lemmon in 2012, the best predictor of mutual fund performance is expense ratio. Remarkably, they found that funds with lower fees outperformed otherwise identical high-fee funds by 32% during the same period.

Matter of fact, the body of research affirming the predictive value of management fees is so compelling that even Morningstar publicly acknowledged that expense ratios alone is a better predictor of future fund performance than their five-star rating system.

Russell Kinnel, Morningstar’s director of fund research quipped, “If there is anything in the whole world of mutual funds that you can take to the bank, it is that expense ratios help you make a better decision.”

Why then do investors continue to buy funds laden with expenses as high as 2% and more? The Pennsylvania scientists note two factors at work.

Two reasons investors pay high fees

The first reason investors flock to high-fee funds is the wrongheaded notion that past performance is the best predictor of future returns. In any given year, top-performing mutual funds are generally actively managed with high expense ratios.

Unfortunately, the majority of these top-performing mutual funds will sink below their benchmark and spiral down, only to be replaced by a new batch of rising stars. Investors’ preference for funds with strong past performance despite high fees, leads them to buy the investment snake oil. These investors sadly look past the steady performance of lower-cost index funds, which, over time, dramatically outperform their higher priced competition.

Not unlike the snake oil customer, these consumers also want to believe in a miracle. They want to believe that there must be someone who can cure their aching joints, return curly locks to their balding head, or in the case of high-price mutual fund investor, make their portfolio grow by leaps and bounds.

The second reason many investors overlook the impact of high fees is what the researchers call cognitive error — simply miscalculating or underestimating the negative effect of high fees. Fund companies don’t state fund fees in dollars, but rather percentages. A fund fee of 2% sounds slight in most investors’ minds.

A closer examination reveals, however, that even this small fee will likely result in a loss of 25% of returns over 10 years. Additionally, the researchers detail these calculations within their study and underscore that with compounding, losses can actually go much higher over a 30-year time horizon.

Furthermore, former SEC Chair Arthur Levitt cited the pervasive fee ignorance by everyday investors. He testified before Congress in 1998 that “our own research shows that fewer than one in five fund investors could give any estimate of expenses for their largest mutual fund and fewer than one in six fund investors understood that higher expenses can lead to lower returns.”

There Is hope

Tess Wilkinson-Ryan and Jill Fisch end their study with a bright discovery. Providing investors with a simple and straightforward education on the negative impact of high-fees resulted in a significant improvement in investor behavior and portfolio performance. Beyond SEC warning and congressional legislation, easily understood education delivered investors from their performance bias and fee ignorance, freeing them from the high-fee, snake oil hoax. Hopefully it is freeing each one of us as well.