“Ignorance is bliss,” or so the saying goes. Unfortunately, as it applies to Wall Street, that bliss is more likely to go to those preying on investors’ ignorance than by those who remain financially naïve. That’s why it’s so important for investors to arm themselves with understanding, at least of the financial basics. For example, here’s one of my favorite lessons: The less you spend on investing, the more you get to keep.
I feel for investors who don’t manage their costs, because they pay a dear price for their inexperience. As John Bogle has famously said, “In investing, you get what you don’t pay for.” Product providers and financial intermediaries who are selling commission-based products often take advantage of unsophisticated investors by marketing high-fee, high-commission funds that earn low returns. I wish there were a way to put a little voice in every inexperienced investor’s head that tells him or her: “Just buy low-cost index funds!” It would go a long way toward solving this serious problem.
The problem is not just theoretical; real dollars are involved. In a landmark 2009 study, Javier Gil-Bazo and Pablo Ruiz-Verdứ studied the relationship between mutual fund performance, management fees, commissions and flow of funds in The Relation between Price and Performance in the Mutual Fund Industry. They found strong evidence that fees paid by clients, commissions charged by brokers, and fund performance was all directly related to client sophistication.
The authors defined “sophisticated investors” as those who were performance-sensitive, and who tended to select funds with lower fees. The least sophisticated investors were buying higher-cost mutual funds that sported the highest management fees and sales commissions. To add insult to injury, these high-fee funds had performed worse, even before fees.
The study noted a negative relationship between before-fee, risk-adjusted returns and fees. Funds with worse before-fee performance charged higher fees than those with better before-fee performance. The existence of high fees and commissions further aggravated the problem of lower returns.
The study also found that underperforming funds had high marketing costs because they were targeting unsophisticated investors that were likely perceived as more responsive to advertising. These investors also seemed more likely to use brokers to purchase mutual funds. Low-performing funds tended to pay higher commissions to brokers as part of their marketing strategy, and this too influenced product sales.
Gil-Bazo and Ruiz- Verdứ concluded that, even after controlling for a host of fund characteristics, underperforming funds charged higher marketing and non-marketing fees. They further inferred that regulation was insufficient to ensure that fees reflected the value that higher-cost funds were presumably supposed to create for investors.
There are plenty of illustrations to indicate that conflicting incentives and high-priced products remain a problem today, especially for naïve investors. As debate continues on whether brokers should be required to prioritize their clients’ best interests ahead of their own profit motives, Labor Secretary Thomas Perez had this to say during a recent Senate panel meeting: “The problem with our system in the U.S. is it incentivizes complexity when simplicity is all too frequently what’s called for. … It incentivizes complexity because complexity generates more fees.”
The solution may or may not be additional legislation. Either way, the best defense against those who prey on investor ignorance is investor education. There’s plenty of good information already available, and it does seem to me as if investors are taking increasing notice of it, but we can always do more. Perhaps a reality television show would help? Somehow a little voice needs to scream, “Just buy low-cost index funds!” every time an investor reads a hyped-up mutual fund advertisement or is pitched a high-cost fund from a broker. In the meantime, I continue to put out my blog and books, and hope for the best.