When Investors Do--and Don't--Pay Attention to Fees

Ray Sin and Ryan O. Murphy are co-authors of this article.

Two new papers on fees and investor behavior--one by Morningstar and NORC at the University of Chicago, and the other by the Financial Conduct Authority of the U.K.--can help us understand how people react to investment fees. Both studies find that investors sometimes don't pay as much attention to fees as one might expect and make common mistakes that can undermine their success. However, these mistakes can be fixed. Let's take a quick look at the findings from each paper and what they mean.

Morningstar's Study On Wednesday, Morningstar released "Expensive Choice: What Wall Street Can Learn From Costco," joint work by Ray Sin and Ryan Murphy of Morningstar's behavioral science team and Angela Fontes and Mark Lush of the NORC at the University of Chicago. In this study, we offered a nationally representative sample of over 3,000 Americans a choice among three virtually identical ETFs tracking the S&P 500 which differed only in price (their names were masked to avoid extraneous signals). One ETF cost 4 basis points, another 9 basis points, and another 40 basis points.

The optimal financial choice with these options would naturally be--no surprise here--to invest all of one's money in the cheapest fund. But that did not happen. Instead, only 42% of the funds went to the cheapest option; 31% to the ETF priced in the middle, and 27% to the most expensive ETF.

We then tested three different interventions to nudge investors to be more sensitive to fees: displaying fees in dollars and cents terms instead of percentage points, displaying performance as annual versus cumulative numbers, and changing the allocation process from "invest as you like" to "select one ETF for all of your money." The first two showed no statistically significant impact on people's investment choices; how the fees were displayed didn't matter. The last one however--focusing attention on one investment rather than splitting money across multiple funds--decreased the amount of money going to the most expensive ETF by 7%. In other words, handling the additional choices can be distracting, and asking people "Is this something you would feel comfortable going 'all in' on" can nudge people to take fees into account better.

Financial Conduct Authority's Study In addition, the Financial Conduct Authority released a paper in April entitled: "Now You See It: Drawing Attention to Charges in the Asset Management Industry." It attacked the same question--how investors respond to fees--from a different angle. The paper presents an online experiment with 1,000 unadvised individual investors in the U.K. in which the participants used a simulated investment platform to select among actively managed U.K. equity funds. The researchers selected pairs of funds which were broadly the same except for cost. The researchers then studied how much the participants invested in the higher versus lower cost funds, depending on how the fees were presented.

Even with a clear presentation of fees and no significant differences between the funds, 27.2% of the time investors selected the higher cost but otherwise equivalent fund. However, when the researchers provided an additional warning prompt, reminding people to go back to the information provided and review the fees of each fund, that decreased the selection of higher cost funds by 6.2%--much like our results at Morningstar. When investors were reminded and offered fee data directly next to the reminder (making it even easier to compare fees), that decreased the selection of higher-cost funds by 10.5%, a statistically and practically significant result.

Implications These two papers are particularly interesting since they come amid broader trends in the United States toward lower fees. The latest edition of Patricia Oey's annual U.S. Fund Fee Study, for example, covers the significant decrease in asset-weighted fees over the past 15 years. Since 2000, the average asset-weighted fees paid by investors of actively managed funds have dropped by over one fourth, and average asset-weighted fees for passive funds have dropped by 10 basis points.

How can these findings coexist? Decreasing fees in aggregate, but investors seeming to partially ignore fees at the individual level? Both can occur since numerous factors other than individual attention to fees could cause the aggregate decline. Which aggregate factors are at work are not entirely clear. Is it actually caused by every investor making a thoughtful choice based on a careful analysis of fees and value? Or is it a consequence of industry competition, and the broader move to passive (and generally lower cost) investments? Or perhaps the results of major institutional investors driving down costs? We have good reason to believe it's a combination of factors. Investors as a whole may be getting more savvy to fees, but individuals still make mistakes; a combination of big players and a competitive market place are helping reduce fees despite individual-level mistakes.

What do these results mean about investors? We know that some investors always pay proper attention to fees, and some don't pay attention even with additional inducements. However, there is a significant population in the middle who can be helped to pay better attention. For those in middle, we can focus attention on a single investment choice instead of multiple choices at once. And, we set up simple reminders to check the fees. Both of these interventions seem obvious, but they still help. We've all seen cases in which even seasoned investors get caught up in an exciting investment opportunity and forget the basics. This research provides two practical tools to bring our attention back to basics.

This paper and Morningstar.com article are part of the Investor Success Project. Learn more about the Morningstar Investor Success Project and read our latest insights.