ANN ARBOR—Investors should pay closer attention to the operating costs of mutual funds—not just sales fees—when 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 points—a basis point is one one-hundredth of a percent—in 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 flows—not 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 study. 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 high-expense funds.

“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 of mind.”

Related links:

• Lu Zheng
• University of Michigan Business School