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moneysense.ca, 13/02/11
Will Better Fee Disclosure Help?
The report put out by the Task Force on Financial Literacy came in for plenty of criticism because it was stacked with insiders at financial institutions that profit from selling financial products. The Globe and Mail’s Rob Carrick pointed out that Canadians can be made a lot savvier about money with better disclosure of fees, rates, terms and conditions. In a sidebar accompanying the main article, Mr. Carrick says that investors would be better served if investment firms showed us how much we are paying for mutual funds — not just in percentage terms but dollar amounts.
You would expect that if investors were made aware of how much fees they were paying, they would wise up and choose low cost investments. Unfortunately, that doesn’t seem to be case. Consider an experiment described in a paper titled Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds. Researchers asked 391 people selected from Harvard staff members to allocate a hypothetical $10,000 among four real S&P 500 index funds. The funds had different front-end loads and different annual expenses. All subjects received the funds’ prospectus and were provided with a large incentive: they will be paid the profits on their investment at the end of an one-month period but will not be responsible for any losses. Some subjects received additional information in the form of a one page summary of fee information. The optimal portfolio would allocate everything to the lowest-cost fund but the researchers added a twist. All the funds available for selection had different inception dates and hence reported different average annual returns in the prospectus.
The results were dismal. Less than 1 in 5 subjects who were supplied with only a prospectus picked the lowest-fee fund. The group with a one-page cheat sheet that summarized the fund fees improved their portfolio allocation but only modestly. The researchers found that subjects “placed heavy weight on irrelevant attributes such as funds’ annualized returns since inception”. They conclude that “although better disclosure and financial education may be helpful”, their research indicates that “their effect on portfolios is likely to be modest”.
moneysense.ca, 13/02/11
Interesting research. However, even if the improvement is only modest, I think it is worth it. Another thing to consider is that the disclosures shown at the end of the paper are essentially in percentage terms because they show the dollar amount of fees on $10,000. When I think of dollar amount disclosures, I imagine that they are computed for the actual size of the investor’s investment. A front-end load of $575 on a $10,000 investment looks bad enough, but a $14,375 load on a $250,000 investment might attract more attention.
I spent a few minutes skimming the actual paper you linked to. It seems to me that their experimental design was somewhat flawed and does not support some of their conclusions, particularly some of the statements that imply that investors ignore fees and chase return. On the “Appendix C” they gave the study participants, the participants were told that the average annual return quoted “Includes the effect of fees, expenses, and sales loads, but not taxes”. Given that information, it is very likely that some participants *were trying to minimize fees* and used the historical returns as a way of doing that.
However, the study is a good reminder to focus on MER (because past fees are not current fees) and tracking error specifically.
It might also help if financial advisers had more of a fiduciary duty to their clients like other professions
http://bit.ly/fALlsW
I think the investors need to be better educated (and presented with data) that shows how the fees impact (read: reduce) the returns they are gawking over. Until this information is given to them (think “explain it to me like i’m a 10 year old) returns will always dominate.
It is debatable if more disclosure will actually help, although I think it’s a good idea.
I did a post a while back on a similar study – from the results it didn’t appear that more disclosure helped.
http://www.moneysmartsblog.com/should-financial-advisers-disclose-their-commissions/
Interesting stuff indeed.
On the same lines as Sustainable PF, I think until financial institutions write their prospectus in grade-six language, not to mention make financial information much more concise, the majority of investors will not benefit. I think more disclosure will help a bit, but what does that read like? “Here is the money we are going to take and you are never going to see again. Sign here please.”
It would be great to see a pay-per-service model, advisors should be allowed to charge a fee for their advisory services, and if someone wants to select the advisor to action their advice then it’s up to the client to find out what the additional costs will be.
@ Larry, – with all due respect… the fiduciary duty card is played way too much – it makes it sounds like that is all that is required – plenty of people of ripped off by accountants and lawyers despite their “fiduciary duty”
A fiduciary duty sounds good but it is just ethics being legislated and you can’t legislate ethics. A good advisor in any profession feels, and operates with, their own fiduciary duty. A bad one does not. It is foolish and simplistic to think bad advisors would somehow be made ineffective by imposing a fiduciary duty.
This sounds more like the typical Canadian reaction that others are to blame if a person has crappy finances. Easier to blame a lack of fiduciary duty, than to admit one spent too much or did not use common sense and chose to buy or invest in something they did not understand.
If the government and regulators really wanted to fix things (they do not want to fix anything by the way), they would simplify the rules and eliminate all the plans and programs that do little but make the entire process of becoming financially “literate”, far too complicated for the masses. The masses by the way do not spend their time reading personal finance blogs.
HOW?
1. A flat tax as opposed to the rediculously complicated tax return would make things much easy for people to understand and plan around.
2. And only have simple non-registered investing accounts (no RSPs, no TFSAs, and no RESPs, no RDSPs, no locked-in RSPs, no spousal RSPs, etc. etc. etc.) would mean people would no longer have 7 different investment accounts, but rather simply have one investment with a large balance and fewer trades bringing down fees and commissions, etc.
Sounds harsh, but if someone couldn’t understand finances under this scenario than they deserve to be broke.
This won’t happen because if it is simple, than the regulators aren’t needed and they are out of a job, the government would have to make meaningful changes to appease people rather than continuing to confuse them by added more complexity to the system, and investment companies and discount brokers would have fewer trades to make and the consumer would be more empowered to facilitate fee reductions.
I am an advisor and prepare tax returns so I make a living off of all of this confusion. It is a shame that the majority of value I add is just helping people stickhandle around these silly rules. If the above changes were made, I would have to add more meaningful value to stay in business.
Wouldn’t that be better than “financial literacy committees” spending 18 months (a year and ahlf -think about that) to come up with a single report.
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@Michael: Every little bit will help, yes. In this study, a better disclosure of fees among the Harvard workers increased the allocation to two low fee funds from 43% to 52%. If we look at it from the angle of how many more investors made better choices, it is a big jump.
@Viscount: What’s interesting to me about Appendix C is that among the three groups — Harvard workers, MBA students & college students — only the last group showed a significant allocation to high cost funds when the return information was provided. The group that had the prospectus only allocated 44% to the two high fee funds. But when return information was provided this number jumped to 68%. But what’s curious is why there is not such a big jump in the other two groups. The authors theorize that the others may have been motivated enough to find the return data in the prospectus for themselves.
@Sustainable PF, @My Own Advisor: Yes, I believe better disclosure will help but only marginally. If investors seem to be making such poor choices with commodity investments such as index funds, they’ll be even more willing to justify to themselves higher MERs for active funds that show stellar returns. They’ll also justify the higher fees as fair compensation for a high quality manager.
@Rob: I hear you on the financial clutter. In our household we have 3 RRSP accounts, 2 TFSA accounts, 1 investment account & 3 RESP accounts. Our tax situation isn’t all that complicated but it still takes me at least a nice Spring afternoon to get it done.
Great post CC.
“they will be paid the profits on their investment…..but will not be responsible for any losses” I’d like to participate in such a study. By the way, I always find research to support my point of view. (Sorry for the jibe, CC).
1% sounds so trivial but Mrs. Smith, that will be $6,420 per year – Jesus! mother of God!
As an investor in mutual funds I would like to see more of a balance sheet style disclosure. Once a year a very simple statement showing what my closing value value was, how much i contributed, how much my fund made or lost, and how much in $ value, were the fees I paid that year. (that seems to be the big missing disclosure). I would like to see information that is not 6 months out of date on the websites as well.
When I have asked my fund company to give that figure I got a long winded answer of why they can’t give (the yearly fees i paid) it to me. It was based on a complicated mathematical formula making it impossible to give me a figure? I mentioned that it would be interesting if they ever had a tax audit, would they would give the same answer to the CRA?
I see nothing wrong in making both parties disclose what they make. If someone promised to make me a big return and they made a fair return for doing so they should be paid for it. But it should be fully transparent and written in a simple plain format that anyone can understand. (The fund company should be proud of their accomplishments).
In General, fee disclosure alone will not help. Not to sound mean, but people in general have to set aside some time in their day and force themselves to learn the basic’s of investing and maybe even before that, how to make a household budget. If you know nothing about investing or asset allocation for example, how would you know that the “financial product salesperson” across from you in the bank is putting you in the correct investment? From what I have seen, a good number of these people have absolutely no clue and direct an unwitting bank client into random, not well thought out funds.
Your post is mainly targeted at the mutual fund industry. It seems to me as though the mutual fund industry does post their MERs so they do disclose how much fees they charge. I think the bigger stumbling block in the mutual fund “industry”, if you can call it an industry, is how much that your broker is making by putting you into one mutual fund versus a different branded one. In other words, how financially motivated is your broker or advisor to recommend a specific fund company versus another one which could be better for you?
With that being said, I don’t like to buy mutual funds as I’m a stock picker. And where I run into disclosure concerns is in purchasing bonds, coupons and residuals – they bury their commissions into the price of the bond. The only way that I can figure out how much my broker is charging me is to compare the purchase price versus the sale price to see the “spread” on the security and figure that’s the broker’s take on the transaction. I don’t have the ability to just scan down a list to see how much my broker’s taking on, say, a list of 20 bonds – it takes me about 5 minutes of digging to figure out the spread on each bond that I’m looking at and that’s a real pain in the behind.
Maybe it’s because I’m still in a university mindset myself, but it bothers me when I see direct quotations not properly indicated as such with quotation marks. If you’re using someone else’s words, I think it’s a bit dishonest to not clearly indicate this, even if you point generally to the reference material in question.
@Jim: Wouldn’t we all love such an investment? All the upside and none of the downside! Fair point about you can always find some research to support any point of view.
@Paul N: I think we can all agree that more disclosures certainly won’t hurt. I think the type of disclosures you are asking for should be standard. In our group RRSP at work, the year-end statement provides the starting value, contributions, change in investment value, final value and the IRR in the previous 12 months. I would like to see something similar at my brokerage account.
I totally agree with your last sentence. My experience is that too many investors have a grab bag of funds with little or no thought given to overall asset allocation.
@Phil S: Good point about bonds. For direct investors, commissions are still hidden. Discount brokers should just charge a flat fee for bonds. I’d also add foreign exchange to the list of hidden commissions.
@Michael Davie: No dishonesty intended. I’ve put the words from the paper in this post in quotations. I try and be as scrupulous as possible when it comes to attribution. This one slipped through the cracks.
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