One of the vexing questions in the investment world is why many investors are inattentive to fees. While Vanguard has helped create a class of investors that’s fee-conscious and fee-aware, the fact remains that many individual investors remain in high-cost funds (and in other high-fee advisory strategies).
It’s somewhat reassuring that recent data indicate many investors are beginning to pay attention to costs. Based on cash-flow trends from Morningstar through Dec. 31, 2011, it would appear investors are beating a path to the low-cost fund door.
The question is, why aren’t more investors looking at costs? The behavioral economics literature points to one possible explanation: salience. In our daily lives we’re flooded with information and must decide what to notice and what to ignore. This is the idea of “selection attention.” We construct a view of reality not based on a dispassionate weighing of many information sources, but based on the information we choose to notice – or, to use a psychological phrase, the information we “attend to” in our daily lives.
For many investors, it’s easy to lose sight of investment fees and expenses. For one, the investment marketplace is awash with information on past performance and on competing strategies, while fees are simply one or two data points. By the simple measure of the weight of the data available, fees are lost in the sea of complex investment information.
For another, fees are expressed as a fraction of assets. A 1% equity management fee seems small and reasonable. “One percent” just sounds tiny – as in “there’s a 1% chance of rain tomorrow.” But suppose you reframe fees in other terms. Suppose you expect a stock fund to earn 8% over the long run. Assuming inflation of 3% and a tax rate of 25%, you’re in effect paying one out of every three dollars of future expected return in costs.* A fee of “one third of all of the money you make” sounds like a lot, especially when many money managers could do worse than the market averages.
Several behavioral economists argue that salience of fees have played a role in the growth of fund expenses.** It used to be that mutual funds came with up-front sales charges and ongoing expenses for investment management. The sales charge appeared as an explicit deduction on an investor’s account. Over time, many funds gravitated to a model of no or smaller up-front sales charges, with a higher expense ratio paying for investment management and sales charges. Because these expenses were deducted from assets, the researchers argue that investors became less attentive to total fees.
There’s some important evidence that investor psychology is beginning to change. Weak returns over the past decade have highlighted the pernicious effect that high expenses can have. After all, if stocks have returned only 2% a year over long periods, investors paying 1% are beginning to balk at ceding half of their market gains to the money manager—before taxes and before inflation. On the bond market side, in a world of 2% Treasury yields, a bond fund fee of 1% consumes half of the portfolio’s income return. In the adviser community, the growth of ETFs has helped drive down costs for the end investor.
The critical lesson for investors is to be aware of fees, to understand their impact. Investors should consider avoiding the distraction of other investment information, particularly performance data and strategy information, which can lead you to discount the importance of fees.
* 8% return less 3% inflation equals a 5% nominal return. The 25% tax rate assumes a blend of taxable and tax-deferred accounts with different rates of taxation. Taxes are equivalent to 25% of 8% or 2%. That leaves a net return of 3% after inflation and taxes—and a 1% fee is 1/3 of that amount. This hypothetical example does not represent the return on any particular investment.
** Barber, Brad M., Terrance Odean and Lu Zheng, “Out of Sight, Out of Mind”
Notes: All investing is subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk. Past performance is not a guarantee of future results.