For years, researchers have tried to determine if mutual fund investors pay attention to — or simply ignore — fees when choosing where to put their money. They have done on-campus controlled experiments presenting investors with different types of prospectuses, as well as an experiment providing investors with a straightforward summary of fees.
But no real-life examples existed until the start of 2006 when India decided to change, twice over the course of three years, the way mutual fund fees were charged. Wharton business and public policy professor Santosh Anagol and PhD student Hoikwang Kim analyze what happened during this period in their recent study, “The Impact of Shrouded Fees: Evidence from a Natural Experiment.” Based on the evidence they gathered, the two researchers conclude that investors ignore fees when choosing mutual funds, and that so-called shrouded fees, which are amortized and charged on a monthly basis, end up hurting these uninformed consumers. “This paper contributes to a small but growing literature arguing that people simply don’t pay attention to fees when making these kinds of decisions,” Anagol says.
India’s mutual fund market, like the one in the U.S., includes both closed-end and open-ended options. Traditional open-ended funds in India have historically been more popular because, as in the U.S., investors can join or withdraw money at any time. Closed-end funds in India are actually more similar to open-ended funds, the only difference being that investors in Indian closed-end funds can only withdraw money at certain intervals (typically the last few days of the month).
Both funds have their advantages: Open-ended funds allow investors to put money in and take money out when they choose, whereas closed-end funds are a more secure investment in a volatile market because all investors are locked in up to a fixed point. Before the Indian policy changes in 2006, both types of funds could charge the same types of fees and gradually deduct them from investors’ accounts over a certain period.
But after 13 years of the private sector offering these two types of mutual funds under the same fee structure, the Indian government decided to institute some changes. In April 2006, government officials ruled that the much more popular open-ended mutual funds now could only charge entry load fees — a one-time charge to investors when they entered the fund. Closed-end funds still could charge initial issue expenses and spread out the costs over a portion of the life of the investment. “When the investor receives his first statement, he will immediately realize that money has been taken out for the entry load,” the researchers write. “Because initial issue expenses were amortized over three years [however], the amounts removed for these costs are likely to have been hidden amongst market movements over time,” and therefore are less noticeable to investors.
In January 2008, the Indian government changed its mind again, saying that both closed-end and open-ended funds could only charge one-time entry load fees. In addition, it did away with amortized initial issue expenses.
What prompted the Indian government to make these major changes so quickly? The first change was to “increase transparency on the total fees investors were being charged,” according to Anagol and Kim. The Indian government made the second change after deciding that the initial modifications didn’t go far enough. In particular, Anagol says, it appears that the Indian regulator may not have been happy with the emergence of closed-end funds that was primarily due to policy changes. The researchers note that in India, unlike the United States, regulatory change happens very quickly. “Financial products can sometimes be very complicated for naïve investors to understand,” Kim says. “The financial regulatory authority may need to lower the psychological barrier” created by complex fee schedules or use of language that is difficult for a non-professional to grasp.
Shrouded Fees Take Over
Instead of protecting investors, however, the first change simply spurred an onslaught of closed-end mutual funds. Prior to the first change, open-end funds dominated the market, the study notes. During the 66-month period before the change, for example, 126 open-ended funds started up while just two closed-end funds launched. During the 22-month period after this change, 45 new closed-end funds were initiated, about one-third of them just before the regulations changed again. Open-ended funds remained popular, however, with 55 starting up. After the January 2008 change went into effect, no closed-end funds were created in the following 20 months, while 43 open-ended funds were launched.
Anagol says that the only reason to explain the dramatic increase — and then decrease — of closed-end funds was that the companies running the funds were taking advantage of a shrouded fee structure in hopes of collecting more fee income. He notes that these closed-end funds were also marketed rather aggressively, being “pushed and sold, rather than bought and sold.” Anagol adds that 65% of mutual fund sales happen through brokers in India; during this period it is likely that brokers first suggested that consumers buy closed-end funds before offering the lower fee open-end fund variety.
According to the paper, fund companies estimated that the fees for closed-end funds averaged 6% of an investor’s return, the maximum by law for both types of funds, while the open-ended funds charged 1.75% on average. (Mutual fund fees in the United States are typically a fraction of 1% of return on investment.)
Despite this dramatic contrast, however, investors did not pay attention to the total fees, Anagol and Kim point out. “Because initial issue expenses were taken out of the net asset value gradually, investors were unlikely to be able to distinguish changes in the net asset value of the fund versus removal of the initial issue expenses. By contrast, investors are more likely to be aware of entry loads because these are deducted in a lump sum fashion from the initial investment,” the report states. “Furthermore, mutual fund advertisements for closed-end funds typically advertised a zero entry load and only described the initial issue expenses in the later pages of the offer document.”
And the closed-end fees were indeed shrouded, the researchers say. For all new open-ended funds, the entry loads were clearly stated on the offer documents and fund website. However, for closed-end funds, Anagol and Kim found only a third of new funds reporting specific initial expense fees. Another one-third simply referenced the law that fees could not exceed 6%. For the remaining one-third of funds, the researchers could not find any documented indication of initial expense costs.
During this surge of closed-end funds, open-ended funds continued in popularity despite having more apparent fees. The currently available data does not allow for an evaluation of what types of investors were harmed by this reform, but there is some evidence that there were different impacts. Some investors continued to invest in open-ended funds during this period, suggesting that not all investors were willing to pay the high fees for closed-end funds.
Cost of Shrouded Fees
The report notes that during the 22 months after the first change, the high fees for the closed-end funds ended up costing investors an estimated extra 4.25%, or $US 500 million, in a mutual fund market that has approximately $US 90 billion of assets under management, and is growing twice as fast as the U.S. market, according to the report. “The amount of money involved in this is substantial,” Anagol says. “People think ‘India’ and [therefore] it’s not a big deal. But mutual funds in India are a growing market with real money involved.”
Moreover, this extra $US 500 million got investors very little in terms of fund value. In the United States, investors often accept higher fees to retain a fund manager with a good track record or to stay with a highly-regarded company, anticipating that the fund is likely to perform better, Anagol notes. But in the case of India, the closed-end funds with much higher fees actually performed slightly worse than their open-ended counterparts. According to the study, closed-end funds had an average monthly return of negative .0039 while open-ended funds had a return of .0000. “Thus, we find no evidence that investors received better performance for the higher fees that closed-end funds charged,” the report states.
Another argument for higher fees on closed-end funds, Anagol says, is that they could be safer in a bubble market because investors do not have to worry about others in the fund rushing to cash out. But he notes that the market performance was relatively similar before, during, and after the policy changes, which essentially deflates this argument.
Although past experiments have indicated that investors ignore fees, the complete disregard for such high fees in the Indian experiment came as a surprise to both Anagol and Kim. “I believed rational investors would have shrewdly reacted to the shrouded fees of closed-funds,” Kim says. “To the contrary, investors were not so savvy in selecting financial products and had to pay a sizable amount in additional fees.”
Lessons Learned
When the second change went into effect on January 31, 2008, forcing both closed and open-ended funds to only charge entry load fees, the proliferation of new closed-end funds dropped off. This decline came after a large spike in new closed-end funds just before the revised regulations went into effect. Once the fees of closed-end funds became “un-shrouded,” investors could no longer be misled into paying much higher fees, Anagol and Kim note.
“By re-framing those issue expenses as entry loads, it appears that closed-end funds were forced to compete with open-ended equity funds,” the researchers write. “And in the investors’ eyes, they were not a good enough product to warrant the extra expense.”
Anagol says that not only does this natural experiment show that investors pay little attention to mutual fund fees in general; it also shows that investors are more aware of fees when they are presented up front. Other research has shown that investors do respond more to higher entry loads but less to fees that are charged later, such as operating expenses. According to the paper, “In light of the recent experimental literature that finds many framing manipulations to be unsuccessful in changing investors’ fund choices, the ‘un-shrouding’ reform studied here appears to have had large effects.”
As for the broader implications, Kim says their research suggests that individual investors — in any country — could benefit from financial advisors bearing sound advice, and that such advisors should be more available to the average person. “Individual investors are not as savvy in their financial management, so [they will probably benefit] when they have easy access to financial advisors.”
Anagol notes the importance of the study in light of the recent Dodd-Frank Wall Street Reform and Consumer Protection Act. He says that U.S. regulators can learn a lesson from the Indian mutual fund experience in that they need to think ahead about how investment firms are going to respond to changes in disclosure policies. In addition, regulators need to be sure that new disclosure rules don’t actually create another way for firms to hide fees, as was the case in India.
“Now that the U.S. is creating a Consumer Financial Protection Bureau, there is going to be more research and thinking about how we can improve disclosure so that individual investors are made more aware of fees and product characteristics,” Anagol says. “An important challenge for the CFPB will be to understand what new products firms may introduce to work around disclosure policy rules.”
