Portfolio Monitoring Costs, Mutual Fund Fees and Portfolio Diversification

Abstract

Investors select from the continuum of investment choices. Almost one in every two households make a very special investment choice, they invest in mutual funds. Empirically, mutual funds underperform, especially net of fees. When making financial decisions is associated with a monitoring cost, the investor may optimally agree to pay high fees to fund managers of an average or even inferior investment ability and to pay for passive indexing. Models without frictions and models with more traditional types of frictions, transaction costs and search costs, can not explain such mutual fund investments. I compare sensitivity of acceptable mutual fund fees to monitoring costs and to transaction costs. If index fund managers exactly replicate the market in expectation, an investor facing low monitoring costs of .01% could be willing to pay a 4.38% load or a 2.78% management fee for delegated indexing. Unrealistically high proportional transaction costs of 3% are consistent with a 3.66% load or a .68% management fee. While transaction costs could possibly explain most of the observed loads, they cannot explain the range of the observed management fees. Search costs may explain the coexistence of different index mutual fund fees, but not the level of fees. In addition to the empirically observed mutual fund fee structures, even modest levels of monitoring costs do explain a wide array of other empirically-observed investment choices as well. In particular, some investors should optimally hold an undiversified portfolio of individual stocks, while others should combine directly held stocks with mutual fund investments, yet another group of investors should opt to own no risky assets at all.