Why Do Mutual Fund Expenses Matter

AbstractThis article develops a theory that the intensity of investor monitoring explains much of the relationship between expenses and performance. I instrument for investor monitoring through the use of minimum initial purchase data to test the theory. I find that the highly publicized negative expense-performance relationship disappears among funds that cater to a sophisticated clientele of investors. I find that mainstream investors can use the existence of a share class with a high minimum initial purchase requirement as a signal of competitiveness. My results highlight the important influence investor monitoring has on the competitiveness of financial products.© 2012 Academy of Financial Services. All rights reserved.JEL classification: G02; G11; G23Keywords: Mutual fund performance; Mutual fund fees; Mutual fund industry competition; Investor sophistication; Monitoring(ProQuest: ... denotes formulae omitted.)1. IntroductionIn the absence of market frictions, the price of a good should be commensurate with its quality. However, contrary to the predictions of Grossman and Stiglitz' s (1980) equilibrium model, a plethora of empirical studies have made it a virtually stylized fact that the net-of-expense performance of a mutual fund is decreasing in expenses.1 This puzzle begs the question of why mutual funds are uncompetitive in their offerings to the market. The purpose of this article is to put forward and empirically analyze the possibility that the negative relationship between expenses and performance is explained by relaxed monitoring standards (or oversight) of investors.There is a substantial body of literature that shows that most individuals who invest in mutual funds possess little knowledge of these products. In a survey of 3,386 investors, Capon, Fitzsimons, and Prince (1996) found that most of the individuals surveyed did not know the investment objective of their mutual fund or even if it is a domestic or international fund. Additionally, most of those surveyed considered fees to be of relatively little importance in the mutual fund selection process. In the analysis of a survey of 2,000 investors conducted by the Office of the Comptroller of the Currency and the Securities and Exchange Commission, Alexander, Jones, and Nigro (1998) found that most of those surveyed did not know their largest fund's expenses, even at the time they made their initial investment in it. Wallison and Litan (2007) also conducted a survey that showed similar results, even among individuals in the highest quintile of self-reported investment knowledge. When Wilcox (2002) performed a fund choice experiment on 50 investors, he found that most of his study participants paid less attention to fees than past performance, even though past performance provides little indication of future performance.In a related strand of the literature, Elton, Gruber, and Busse (2004) and Hortascu and Syverson (2004) examined the market for S&P 500 index funds, where price should be the sole decision criteria, and found that more money has flowed into the most expensive funds than the least expensive funds. Moreover, a lack of attention to expenses in the market for index funds was also apparent in a study conducted by Choi, Laibson, and Madrian (2009) on two ivy-league campuses. When fees were clearly stated in a one-page tear sheet, only 20% of the 720 study participants, whose average SAT score was in the top decile of the general population, chose to invest only in the cheapest fund.Taken together, prior research shows that people make rather uninformed decisions when selecting a mutual fund. However, according to the Investment Company Institute's Investment Company Fact Book (2011), the median account balance of mutual funds was only $49,052. This suggests that they make uninformed decisions because, as formalized in the next section of this article, the improvement in portfolio performance from investing additional time into the fund search process is not large enough to justify their allocation of (costly) time to such tasks. …