New Study Links Poor Fund Performance With Higher Fees

Personal Finance StudyA 2013 Rotman School of Management study published in the February Journal Of Finance found that mutual funds offering higher fees attract the most investments, particularly when the broker isn’t directly affiliated with the mutual fund. This is a common problem in the investment area. People have been programmed with years of marketing and advertising that more expensive things are inherently better. The old idiom: “You get what you pay for.” Holds true in many places, but as this study suggests, not for investments.

The study analyzed how the broker fees correlate into managed assets. Many studies focus on fees versus returns; this study uniquely correlated fees with the amount of assets under management. For each additional dollar that the broker makes, another six dollars comes under management. The amount of money under management per dollar of compensation to the broker spikes to $14 if the broker is an unaffiliated third party who works off of commissions.

This isn’t inherently bad. If paying a professional for investment advice yields higher returns, that’s a completely sensible thing to do. However, the study correlates unaffiliated brokers with significantly worse performance. The 2.3% average fee that they charge corresponds to a 1.13% reduction in annual performance. This is like them charging an additional percentage point on top of their 2.3% management fee. While it may seem relatively inconsequential, a 1% fee can account for up to a 17% reduction in final portfolio value[1].

Susan Christoffersen, PhD and Associate Professor of Finance at the Rotman School of Managment says that the problem with brokers is their fees. Christoffersen isn’t sour on the idea of investing help.

09-08-08

Susan Christoffersen

“We’re not questioning, and our results are not implicating, the broker’s value added through asset allocation, and if you tell a novice investor to just choose between index funds by himself, he might suffer from the lack of a broker’s advice.” She says

Coauthor Rich Evans at the University of Virginia adds, “It may be difficult for a novice investor to decide on the best index funds and/or asset allocation without assistance.”

The problem is two fold, and any solution would need to solve both transparency and the bias. This is a challenging problem to solve when an entire industry was built around disclosing very little. Instead of suggesting reforms, coauthor David Musto at the Wharton School suggests empowerment:

“[The research suggests] an investor would benefit from understanding how their broker is paid since we see larger payments to the brokers associating with greater flows to the funds  paying them.”

So the next time you’re writing a check to your financial advisor, ask yourself, “What is it I am really paying for?”

[1] ”Effect of a 1-Percentage Point in Higher Annual Fees on a $20,000 401(k) Balance Invested over 20 Years.” Page 2. Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees

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