Business Professor Research Finds Mutual Funds Take Advantage of Novices
"The mutual fund industry has become very adept at segmenting customers by level of investment sophistication," said Todd Houge, assistant professor of finance in the Tippie College of Business. "The industry uses this ability to market high expense funds to less-knowledgeable customers."
Houge's research paper, "The Use and Abuse of Mutual Fund Expenses," was co-written with Jay Wellman, a graduate of the Tippie College's doctoral program in finance and now an assistant professor of finance at Binghamton University. The paper was published in the January issue of the Journal of Business Ethics.
Houge said he and Wellman found mutual fund companies separate more knowledgeable investors from those who are less so by using sales loads, or commissions that are paid to brokers, financial planners, or other sales representatives to sell the fund to an investor. Mutual fund companies, he said, use the load as a signal of an investor's financial savvy -- those less knowledgeable about investing put their money in load funds, while those who are more financially literate invest in no-load funds that allow investors to invest directly with the company and eliminate the sales agent.
"Knowledgeable investors are more likely to purchase directly from a fund company, avoiding all sales commissions," Houge said. "Less-knowledgeable or less-confident investors are more likely to seek assistance from a broker or financial advisor, who receive commissions for selling load funds to investors. No one questions the need for the advisor to be paid, but the problem is, many investors do not know how much their advisor is being paid. When you pay a load, you know what you're paying up front, but it is more difficult to know what you're paying when additional fees are also based on a percentage of the fund's net asset value."
Houge and Wellman examined the loads and fees charged by all stock and bond mutual funds available to U.S. investors between 1970 and 2004, except for money market funds and international stock funds. The fund industry changed radically during those years, he said, as only a few hundred mutual funds were available in 1970, nearly all of which charged sales loads to investors. By 2004, however, thousands of funds were available, and most of them were no-load. The exploding popularity of no-load funds forced many funds to reduce their loads or eliminate them entirely, Houge said. Today, no-load funds also tend to charge lower asset management fees and have lower total expense ratios, giving do-it-yourself investors the opportunity to save money and further decreasing the appeal of load funds.
Houge and Wellman compared fees in load and no-load funds and found that from 1970 to 2004, fees for no-load equity funds stayed relatively stable, ranging from .70 percent in 1970 to .88 percent in the 1980s and then falling back to .67 percent in 2004. Fees for load funds, however, more than doubled, from .55 percent in 1970 to 1.17 percent in 2004.
Houge said the fund companies do this with a federal law that allows them to pass along advertising and marketing costs to the fund's investors via an annual expense ratio. However, he said these so-called 12b-1 fees (named after the part of federal law that allows them) are used for more than just marketing or advertising expenses. He said this makes the 12b-1 fees essentially a hidden replacement for sales loads.
"The original purpose of the law was to allow fund companies to attract new investors, which in theory would allow them to pass the savings of economies of scale onto existing investors," said Houge. "But most load funds today charge 12b-1 fees far in excess of their marketing costs and use it as just another profit center to extract wealth."
In fact, he said many funds that are closed to new investors still charge 12b-1 fees that are supposed to pay for advertising and marketing costs, even though the fund is no longer advertised or marketed. Houge and Wellman found that in 2004, 119 equity funds and 25 bond funds that were closed to new investors nevertheless continued to charge 12b-1 fees intended for marketing and advertising to attract new investors.
Unfortunately, he said, the type of investors who are most likely to invest in a fund that charges loads likely are not always knowledgeable enough to understand what an appropriate fee would be, or how much they're paying in fees.
Houge said while none of what the fund companies are doing violates federal law, he questions the ethics of it. He said the SEC is currently investigating one potentially effective solution by requiring that funds disclose the dollar amount of operating expenses paid by each shareholder every year, instead of identifying the fee as a percentage of asset value, which is difficult to calculate for a novice.
"The mutual fund industry seems to have currently embraced a path that generates the most profit with the least resistance from investors," said Houge. "This trend makes load funds an increasingly poor long-term investment, dependant on the unsophisticated investor for its continued success."
Contact: Tom Snee, UI News Services, 319-384-0010