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Mutual funds are a popular and effective way to diversify risk, with research showing that they comprise around 58% of retirement savings.
“Mutual funds expose investors to a whole basket of stocks that offer different ‘flavors,’” saidMIT Sloan assistant professor of accounting. This means that they are far more efficient than picking a single stock and being “exposed to all the upside and downside of that stock,” which is “overwhelming and usually incredibly risky,” she said.
Despite their popularity, however, some studies find that mutual funds underperform benchmark portfolios, and that retail investors consistently make poor choices when selecting funds, choosing high-fee funds even when similar low-fee funds are available, Xie and her fellow co-authors note in their new research: “Obfuscation in Mutual Funds.”
Part of the problem is that mutual funds contain complicated disclosures that make it difficult for investors to make informed decisions, the research determined. The Securities and Exchange Commission has recognized this and already expressed concern that mutual fund disclosures need to be less opaque and contain more accessible language, given that many retail investors are making investment decisions on their own.
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“In the case of mutual funds, when retail investors shop for the right fund, they rely on information that funds give out: basic information, such as the returns they would expect to earn and the expenses they would expect to incur,” Xie said.
Xie and her co-authors wondered: Can convoluted writing in disclosures be blamed for investors’ poor decision making? In addition, do complex fee structures make it hard for investors to compare funds and identify the management and maintenance fees and other costs they would have to pay for choosing a certain fund?
To find out, the authors collected a sample of 38 mutual funds from the S&P 500 index between 1994 and 2017. All funds were available to self-directed retail investors. They chose the S&P 500 because these index funds have “largely homogenous” gross investment returns and risks but charge different fees, so they have different net returns.
The authors examined narrative complexity within funds’ prospectuses and the summary prospectuses, a common source of information for retail investors. To measure narrative complexity, they looked at:
- How many unique funds were included in a single prospectus.
- The degree to which the prospectus summary repeated language from the details section, thereby adding confusion.
- How many words were in an average sentence.
- How long the entire prospectus and the summary expense disclosure were.
They also measured structural complexity based on the fund’s number of share classes and types and tiers of fees.
Results showed “strong and positive associations” between fees and narrative and structural complexity. The funds that had greater narrative complexity (less readable disclosures) and structural complexity (more complicated fee structures) were also the ones that charged higher fees, suggesting that perhaps this complexity was designed to “obfuscate” high fees.
The authors were especially surprised by the findings because mutual fund disclosures are heavily regulated and because conventional wisdom suggests that index funds are a cheap way to obtain a diverse portfolio.
The authors suggest that regulators could take the following three steps to help clear up obfuscation.
Simplify language: As the SEC continues to develop and enforce regulations to improve fund disclosure, regulators should encourage simplification and revisit their 2009 decision not to prohibit multiple-fund prospectuses or summary sections that exceed a certain length.
Tighten regulation on fee structures: The authors noted that structurally complex funds are consistently more expensive than simpler funds. “While the SEC has raised concerns about these fees and prosecuted advisors for lack of transparency, it has so far not prohibited them,” they wrote.
Increase advisors’ responsibilities: The SEC requires advisors to recommend financial products that are in a client's best interest but limits their responsibility when making recommendations across mutual funds from different companies. However, given that the researchers find large differences in fees across S&P 500 funds, “the SEC should perhaps consider raising advisors’ responsibilities, at least for highly similar index funds [with different fee structures].”
Xie said it’s important to remember that their findings do not “make the very strong causal claim that this was done intentionally.”
“Strategic behaviors could have evolved unintentionally,” she cautioned, noting that perhaps mutual funds are mimicking what other financial intermediaries are doing, both in terms of complexity and fees.
That said, there is still “evidence consistent with fund managers’ not embracing the SEC’s efforts to reduce complexity in fund disclosures.”
For example, the authors looked at the effects of two 2009 SEC regulations that were designed to reduce narrative complexity. They found that funds with the most narratively complex disclosures pre-2009 reduced their narrative complexity more than other funds after the regulations became effective, “which suggests that prospectus narrative complexity is at least partially discretionary,” the authors concluded.
Overall, “our results indicate that unreadable disclosures are part of a discretionary strategy to extract rents from retail investors,” the authors wrote.
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