Mutual fund operating expenses are often overlooked, U-M study
ANN ARBOR, Mich.Investors should pay closer
attention to the operating costs of mutual fundsnot just sales
feeswhen deciding to invest, according to a University of
Michigan Business School researcher.
Over time, investors have learned more quickly
to avoid mutual fund costs, especially high loads and commissions,
than high operating costs, says Lu Zheng, assistant professor of
finance at the U-M Business School. In fact, the proportion of mutual
fund assets invested in load funds dropped from 91 percent in 1962
to 35 percent in 1999, while operating expenses for these funds
increased by more than 60 percent during that time.
"Purchase decisions of mutual fund investors
are influenced by salient, attention-grabbing information,"
Zheng said. "Investors are more sensitive to in-your-face
fees and are more likely to buy funds that attract their attention
through exceptional performance, marketing or advertising."
Operating expenses, on the other hand, are less
salient than loads, she says. While operating expenses constitute
a steady drain on a fund's performance, the effect of that
drain is masked by the considerable volatility in the returns on
equity mutual funds.
By analyzing diversified U.S. equity mutual fund
flows from 1970 to 1999 and brokerage data from 1991 to 1996, Zheng
and colleagues Brad Barber of the University of California-Davis
and Terrance Odean of the University of California-Berkeley found
a consistently negative relation between fund flows and both load
fees and commissions charged by brokerage firms. In contrast, they
found no association or at worst, a positive one, between fund flows
and operating expenses.
According to the study, a decrease of 100 basis
pointsa basis point is one one-hundredth of a percentin
total expenses (loads, commissions and operating expenses) is associated
with a modest 0.36 percent growth in new money flowing into a fund.
However, when the statistical effects of load
fees and operating expenses are analyzed separately, the negative
relation between total expenses and flows is clearly driven by a
significant negative connection between load fees and flowsnot
by operating expenses, the researchers say.
They say that for all funds, in general, there
is no link between operating expenses and flows, while there is
even a positive relationship for the largest 50 funds, the largest
70 percent of funds and the older, more established funds in the
While the researchers say that mutual fund investors
are more aware of loads and commissions than operating expenses,
low-expense mutual funds enjoy greater average market share than
"Low-expense funds may have greater average market share because
fund growth leads to lower expenses," Zheng said. "Indeed,
many mutual fund prospectuses proscribe reductions in operating
expenses as assets under management grow."
The study shows that new money and strong returns
lead to lower expenses. For example, a 10-percent return is associated
with an average decrease in a mutual fund's expense ratio
of six basis points in the following year.
Zheng and colleagues say that while the search
for mutual funds may be costly, there is no evidence that investors
merely invest in funds that come to their attention through advertising
and marketing, rather than incurring the hassle of finding a fund.
"On the one hand, many, if not most, mutual
fund investors do not minimize search costs," Zheng said.
"On the other hand, even when attention is not an issue, individuals
over-emphasize loads relative to expense ratios."
In all, the researchers say that mutual fund advertising
certainly works. On average, any negative effect of expense fees
on fund flows is more than offset when that money is spent on marketing.
Non-marketing costs, however, reduce fund flows.
Further, though load fees are also spent on marketing,
the positive effect of marketing on flows does not appear to be
sufficient to offset investors' growing awareness of and aversion
to loads, they say.
"Overall, investors would benefit from a
greater understanding and awareness of mutual fund expenses,"
Zheng said. "While educating investors is a complex and multi-faceted
task, our results support the General Accounting Office's
recommendation that one step in that process could be for mutual
funds to disclose to investors the actual dollar amount of fees
paid. Expenses that remain out of sight are likely to remain out
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Contact: Bernie DeGroat
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