Do Investors Really Pay Attention to Fees?
Two studies cast doubt, highlighting need for industry to lead the way.
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 United Kingdom—can help us understand how investors respond to investment fees. In both reports, the authors find that individual investors partially ignore the fees they are paying, with potentially serious consequences. By changing the way in which investments are presented and chosen, however, investors would be more likely to take fees into account. Let’s take a quick look at the findings from each paper and examine what they mean, especially in light of our research that finds that the average asset-weighted fees paid by investors in the United States are declining.
Now You See It (and Apparently, Now They Don’t)
In April, the FCA released a paper by Lucy Hayes, William Lee, and Anish Thakrar titled “Now You See It: Drawing Attention to Charges in the Asset Management Industry.” The paper presents an online experiment with 1,000 unadvised individual investors in the U.K. The participants used a simulated investment platform to select among actively managed U.K. equity funds. The researchers selected pairs of funds that were broadly the same, except for cost. The researchers then studied how much the participants invested in the higher-cost funds versus the lower-cost ones, depending on how the fees were presented.
Even with a clear presentation of fees, 27.2% of the time investors selected the higher-cost, but otherwise equivalent, fund. However, when the researchers provided an additional warning prompt to investors, reminding them to go back to the information provided and review the fees of each fund, the selection of higher-cost funds decreased by 6.2 percentage points. When they reminded investors 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 percentage points— a statistically, and practically, significant result.
Morningstar’s Work on Investor Behavior and Fees
“Why Do People Invest in Overpriced Index Funds, and Can Behavioral Nudges Help?” is a joint work between Ray Sin and Ryan Murphy of Morningstar’s behavioral science team and Angela Fontes and Mark Lush of NORC at the University of Chicago. (The paper is available at http:// www.morningstar.com/learn/fees.) It attacks the same question—how investors respond to fees—from a different angle. A nationally representative sample of more than 3,000 Americans were given a hypothetical $10,000 and a choice to invest among three identical exchange-traded funds tracking the S&P 500. The funds differed only in price. (Their names were masked to avoid extraneous signals.) They cost 0.04%, 0.09%, and 0.4%.
The optimal financial choice, naturally, would be to invest all of one’s money in the cheapest fund. But as with the FCA study, that did not happen. Instead, only 42% of the money went to the cheapest ETF, while 27% went to the most expensive fund. We tested three different interventions to nudge investors to be more sensitive to fees: displaying fees in dollars and cents 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. The last one did. It decreased the amount of money going to the most expensive ETF by 7 percentage points.
Wait a Minute…
These two papers are interesting because they come amid broader trends in the United States toward lower fees. According to Morningstar’s latest study on fees, since 2000, the average asset-weighted fees paid by investors of actively managed funds have dropped by more than one fourth, and the average asset-weighted fees of passive funds have dropped by 10 basis points.
How can these findings coexist? Asset-weighted fees are decreasing, yet investors seem to partially ignore fees at the individual level? Both can be true because numerous factors could cause the aggregate decline. Is it caused by individual investors making thoughtful choices based on a careful analysis of fees and value? Or is it a consequence of competition and the broader move to passive (and generally lower-cost) investments? Or perhaps it is the result of major institutional investors driving down costs? We have good reason to doubt that everyday retail investors are solely responsible for driving these trends, which leads to important lessons for public policy regarding how investments are presented to retail investors.
To better understand this research and its implications, let’s dive deeper into the new Morningstar report on investor behavior.
How the Morningstar Study Worked In the paper by Morningstar and NORC, we presented a randomized experiment with a nationally representative sample of 3,622 participants. In the experiment, we asked participants to allocate a hypothetical $10,000 across three real S&P 500 ETF index funds (with pseudonyms). As noted above, the funds were indistinguishable except for their expense ratios. To understand how investors might select investments, we tested different ways to present the options, drawing on ongoing debates in the policy and industry arenas. Some participants were randomly assigned to see fees in terms of current dollar cost or in terms of percentages. The study also varied the format of the performance: Either bar charts showing prospectus-style year-by-year returns or a line graph showing the historical growth of $10,000 were displayed.
Our results suggest that changing how fees and performance are displayed did not help people choose the most cost-effective option. In fact, on average, only 14% of the participants put all of their money in the cheapest option and did so regardless of how the fees and performance were displayed. However, we found that modifying how selections were made—i.e., whether investors faced multiple choices in how to allocate their money—did drive down unnecessary spending on higher-fee funds.
Diversification Efforts Can Backfire
We also randomly assigned the type of investment decision that investors faced. Half of the participants could choose only one ETF to allocate all of their funds to. The other half were free to allocate the $10,000 in any manner across all three options. By comparing the average allocation decisions between both groups, we can identify why people might choose higherpriced investments, even though there are cheaper, essentially identical alternatives available.
In both situations (choose only one or choose allocating freely among many funds), the optimal decision is to allocate all resources to the cheapest option. Some participants did not follow this logic, however. On average, participants who were asked to allocate freely across all three options allocated 27% of their funds to the most expensive ETF, 31% to the middle ETF, and 42% of their funds to the cheapest, which indicates that people were diversifying across all options.
In contrast, when participants were restricted to allocate all of their money to only one fund, people invested significantly more in the cheapest ETF: About 47% chose this option when constrained to make one choice, versus 13.7% choosing to place all of their funds in the cheapest option when they were not constrained. The proportion of funds allocated to the most expensive fund fell to about 20%. This demonstrates that price sensitivity can be increased and that multiple options may distract people from a purely economic assessment of the best investment for their funds.
Paying for Choice
These results suggest that participants were resorting to a decision-making shortcut called “naïve diversification.” In an attempt to spread out risk and avoid making the wrong choice, participants essentially followed the popular mantra, “Don’t put all your eggs in one basket.”
This strategy can be triggered by choice overload, a cognitive phenomenon linked to the complexity of a decision-making context. Unfortunately for individuals, investment decisions are a perfect example of such a context. Investment decisions come with the cognitive difficulty stemming from risking hard-earned money, technical jargon, calculations that many individuals find daunting, and an inordinate amount of information and alternatives that add to the complexity. It’s only natural for individuals to resort to a shortcut like naïve diversification and allocate their money somewhat evenly across all available options, even ones that are overpriced.
The data shows that those who resorted to naïve diversification, on average, paid about four times more in fees, even though all three ETFs are indistinguishable in terms of performance and portfolio holdings. Not only do our results show that when faced with multiple options do investors invest in suboptimal funds, but the fees they incur directly undercut their returns.
How to Present Fees to Retail Investors
Our study suggests that naïve diversification may be costing investors additional fees by inducing them to make suboptimal investing decisions. Fund companies will likely continue to offer equivalent funds at disparate prices, and proposed changes to fee disclosure (like dollar-valued fees) don’t appear to be effective on their own. But the financial industry can help investors avoid this decision-making mistake in other ways: by curating out higher-priced but otherwise similar options and leaving a set of investments that are structured to yield good portfolios even if investors uniformly spread their money among the available alternatives.
What This Means for the Industry
When left to their own devices, a substantial number of people do not make optimal choices with respect to costs. An important takeaway from these experiments is the importance of the investment decision ecosystem. The typical investor does not make investment decisions in a vacuum. He or she engages with intermediaries such as advisors, regulators such as the SEC, and financial research companies such as Morningstar.
As evidenced by our experiment, relying on fees alone as a market differentiator may not be enough to attract investors. Transparency and lowering fees are necessary but, ultimately, insufficient. Advisors and fund providers can tailor the choice environment to help real people make smart decisions, even when they feel hurried, overwhelmed, and unsure.
 Oey, P. 2018. “U.S. Fund Fee Study: Average Fund Fees Paid by Investors Decreased 8% in 2017, the Largest One-Year Decline Ever.” Morningstar white paper: https://www.morningstar.com/lp/annual-us-fund-fee-study.
 Benartzi, S., & Thaler, R.H. 2001. “Naïve Diversification Strategies in Defined Contribution Saving Plans.” The American Economic Review, Vol. 91, No. 1, pp. 79–98.
 Iyengar, S., & Lepper, M.R. 2000. “When Choice Is Demotivating: Can One Desire Too Much of a Good Thing?” Personality Processes and Individual Differences, Vol. 79, No. 6, pp. 995–1006.
This article originally appeared in the June/July 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.