High-fee Funds Research Articles

Moving the Goalposts? Mutual Fund Benchmark Changes and Relative Performance Manipulation

Abstract We analyze changes to mutual funds’ self-declared benchmarks using hand-collected data from funds’ prospectuses. Under existing rules, funds can freely change their benchmark indexes and, implicitly, the historical returns to which they compare their past performance. Funds exploit this loophole by adding (dropping) indexes with lower (higher) past returns, thereby materially improving the appearance of their benchmarkadjusted returns. High-fee funds, broker-sold funds, and funds experiencing poor performance and outflows are more likely to engage in this behavior. These funds subsequently attract additional flows despite continuing to underperform their peers. (JEL G11, G14, G20, G23, G50, G53)

Cheaper Is Not Better: On the ‘Superior’ Performance of High-Fee Mutual Funds

Abstract In contrast with theoretical predictions, high-fee active equity funds generate worse net-of-expenses performance. We show that this fee-performance puzzle is driven by the preference of high-fee funds for stocks with low operating profitability and high investment rates, characteristics associated with low expected returns. After controlling for exposures to profitability and investment factors, we find high-fee funds significantly outperform low-fee funds before expenses and achieve similarly poor net-of-fees performance. In resolving the fee-performance puzzle, our findings provide support to the theoretical prediction that net alphas are unrelated to fees and challenge the common advice to prefer low-fee funds over high-fee counterparts. (JEL G23, G11, J24) Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Financial fraud and individual investment behavior

We show that, after the revelation of financial fraud in a major pension fund manager, two-thirds of affected investors fail to divest. Inert investors are on average younger, of lower SES and more influenced by default options. The majority of those who divest move their money to the only state-run option on the fund menu. The revelation of fraud also induces a small movement of investors from non-fraudulent private investment funds to the state alternative. We further show that most fraud victims end up in underperforming high-fee funds through their prior affiliation with a subscription-based financial advisor. Our analysis is based on the remarkable events surrounding the expulsion of Allra from the Swedish Premium Pension, and administrative, individual-level data on mutual fund choices and background characteristics. Our results illustrate that fraudulent fund managers may exploit widespread consumer biases in choice-oriented pension plans, and that information interventions by the government are important but far from fully effective in nudging victimized investors to take the right action. Pension plans may be characterized by investor inertia even under extreme circumstances such as fraud.

The Persistence of Fee Dispersion among Mutual Funds*

Abstract Previous work shows large differences in fees for S&P 500 index funds and other funds and suggests that investors suffer wealth losses investing in high-fee funds when similar low-fee funds are available. In contrast, the neoclassical model of mutual funds (Berk and van Binsbergen, 2015, J. Financ. Econ., 118, 1–20) argues that percentage fees are irrelevant, as fund size will adjust in equilibrium such that net alphas are equal to zero. We show that fees matter from an investor perspective. We document (i) a strong negative association between net-of-fee fund performance and fees in a sample of all US and international equity funds, (ii) economically large, robust, persistent, and pervasive fee dispersion in the mutual fund industry, and (iii) important economic effects for investors. During the sample period, the mutual fund industry has generated a total value lost (i.e., a negative net value added) of 125 billion USD, coming predominantly from high-fee funds.

Financial literacy and retail investors' financial welfare: Evidence from mutual fund investment outcomes in China

This paper examines the financial literacy of mutual fund retail investors and its relationship with their investment outcomes. Using a unique dataset on Chinese mutual fund retail investors containing a survey on financial literacy, we find that women display significantly lower financial literacy than men. Investors with a higher level of education and richer investment experience have higher financial literacy. A one-standard-deviation increase in advanced financial literacy is associated with a probability decrease of an individual investor suffering a major loss by 1.940 percentage points, >13% of the sample average. Highly literate investors also show more sophistication concerning fee-related issues: they are more likely to be aware of investment charges, to avoid high-fee funds sold by intermediaries, and to trade less. Moreover, we find that advanced literacy has a significantly larger impact on investment performance than basic literacy. These results can be helpful to the policy debate on the effects of financial education.

Cheaper is Not Better: On the Superior Performance of High-Fee Mutual Funds

The well-established negative relation between expense ratios and future net-of-fees performance of actively managed equity mutual funds guides portfolio decisions of institutional and retail investors. We show that this relation is an artifact of the failure to adjust performance for exposure to the profitability and investment factors. High-fee funds exhibit a strong preference for stocks with low operating profitability and high investment rates, characteristics recently found to associate with low expected returns. We show that after controlling for exposures to profitability and investment factors, high-fee funds significantly outperform low-fee funds before expenses, and perform equally well net of fees. Our results have important implications for asset allocation decisions and support the theoretical prediction that skilled managers extract rents by charging high fees.

An Equilibrium Theory of Retirement Plan Design

We develop an equilibrium theory of employer-sponsored retirement plan design using a behavioral contract theory approach. The operation of the labor market results in retirement plans that generally cater to, rather than correct, workers' mistakes. Our theory provides novel explanations for a range of facts about retirement plan design, including the use of employer matching contributions that result in cross-subsidization of rational workers by myopic workers, the use of default employee contribution rates in automatic enrollment plans that lower, rather than raise, workers' savings, and the inclusion of high-fee funds among plans' investment options. These equilibrium outcomes call into question the practice of depending on employers to design plans to counteract the mistakes of workers.

The Relationship between Australian Mutual Fund Fees and Risk‐Adjusted Performance in Differing Economic Conditions

We find that Australian mutual fund investors should avoid high fee funds as these funds generate relatively low after‐fee risk‐adjusted returns both unconditionally and in weak economic conditions. This result is different from some of the previous findings which showed that US mutual funds with relatively high expense ratios may generate relatively higher risk‐adjusted returns during recessions relative to non‐recessions, although their unconditional alphas may be negative. We find some support for the Glode hypothesis in surviving Australian wholesale funds. High‐fee surviving Australian wholesale funds perform relatively strongly in both weak economic conditions and unconditionally. High‐fee funds in other types of Australian mutual funds generally do not perform strongly either in weak economic conditions or unconditionally. Amongst low‐fee funds, we commonly find that those that perform well unconditionally and well in weak economic conditions do charge more than those that perform well unconditionally and poorly in weak economic conditions. Amongst low‐fee funds, it is often true that those that perform poorly unconditionally but well in weak economic conditions can charge more than those that perform poorly unconditionally and poorly in weak economic conditions.

Improved Performance Guarantees

Many mutual fund shareholders invest in funds with supra-competitive fees that reduce their expected return even though lower cost alternatives are available. While financial arbitrage could address this problem, conventional arbitrage is difficult to implement in the mutual fund market. This article proposes legal reform to our system of mutual fund regulation that responds to the problem of high-cost funds by providing the investors who are making the most substantial mistakes with salient and transparent market information about the existence of superior investment alternatives. We first consider ways that regulation could be reformed to facilitate what we call redemption, the mutual fund analog to of securities. A vibrant market for short redemptions would allow smart money to arbitrage fee differences by selling (redeeming) short high fee funds while buying comparable low-fee funds. But because of predictable resistance from the shorted funds and the difficulty of obtaining shares to borrow, we conclude that the short redemption is unlikely to be sufficient arbitrage discipline of inefficient high fee funds. Instead, we propose regulatory reform that would encourage low fee funds to offer performance guarantees. An improved performance guarantee promises that the consumer will achieve a better net financial outcome if she switches from a current provider to a competitor product. The core notion is to guarantee to the consumer an improvement in relative performance. The guarantee functions as an arbitrage of high fee funds that would improve price competition in the mutual fund market. Our central claim is that lawmakers and regulators can enhance competition in mutual funds by enabling sophisticated investors to arbitrage supra-competitive fees.

Do Funds Make More When They Trade More?

We find that active mutual funds perform better after trading more. This time-series relation between a fund’s turnover and its subsequent benchmarkadjusted return is especially strong for small, high-fee funds. These results are consistent with high-fee funds having greater skill to identify time-varying profit opportunities and with small funds being more able to exploit those opportunities. In addition to this novel evidence of managerial skill and fund-level decreasing returns to scale, we find evidence of industry-level decreasing returns: The positive turnover-performance relation weakens when funds act more in concert. We also identify a common component of fund trading that is correlated with mispricing proxies and helps predict fund returns.

Money for Nothing? Understanding Variation in Reported Hedge Fund Fees

We analyze the determinants of hedge fund management and incentive fees in a large consolidated hedge fund dataset. We detect time-series variation in fees by concentrating our attention on fund launches, and conditioning fees at launch on fund family characteristics. Larger and better performing fund families launch high fee funds.

Market penetration strategies and the fee–performance relationship: the case of Spanish money mutual funds

This article shows that market penetration strategies are common practice during the product introduction stage in the money mutual funds in Spain. During this stage there is no relation between fees and performance because this strategy is optimal. In order to analyse this relationship during the other stages of the product life cycle, funds under three years old were omitted from the analysis. Among the remaining funds, those with the highest fees are found to present a higher gross return than the low-fee funds, although the difference is not statistically significant. Nevertheless, in terms of net returns, low-fee funds are observed to stochastically dominate high-fee funds for any risk-averse investor. These findings hold for any managerial skill level or segmentation by the mutual fund family type.

Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds

We conduct an experiment to evaluate why individuals invest in high-fee index funds. In our experiments, subjects allocate $10,000 across four S&P 500 index funds and are rewarded for their portfolio's subsequent return. Subjects overwhelmingly fail to minimize fees. We can reject the hypothesis that subjects buy high-fee index funds because of bundled non-portfolio services. Search costs for fees matter, but even when we eliminate these costs, fees are not minimized. Instead, subjects place high weight on annualized returns since inception. Fees paid decrease with financial literacy. Interestingly, subjects who choose high-fee funds sense they are making a mistake.