The Mutual Fund Conundrum

With the close of Financial Literacy Month, we explore how limited financial knowledge can impact a household’s financial health. A high percentage of Americans don’t possess the necessary “financial literacy” to make good financial decisions[1] The increasing complexity of financial products is magnified by the asymmetric information available between institutional sellers and retail buyers. These dynamics increase the difficulty of consumers’ acquiring a true understanding of the various programs and products available to investors.

Nominal economic theory tells us that consumers stop gathering data when the marginal benefit of an additional hour of research equals the marginal cost of that hour of research. Time and attention are scarce resources. To reduce “information acquisition” costs, many would-be investors purchase funds that are easily recognized in the marketplace. Research has shown that individual investors are eager buyers of attention-grabbing stocks and mutual funds – publicly owned companies and mutual funds that frequently appear in the news.[2] Stocks experiencing abnormally high trading volume and hot issues with extreme one-day returns grab headlines. When there is a panoply of alternatives, options that attract attention are more likely to be considered. High-performing funds promoted through shareholder-financed marketing and advertising budgets occupy the most desirable “shelf space,” are the most visible, and exert the greatest influence on purchase decisions at minimal time-search “cost” to the investor.

Access to information through the internet makes it appear as if investors can lower their marginal cost of gathering information, yet it is difficult to determine the quality of information gathered. Information overload and the inability of consumers to distinguish between financial data based upon high-quality economic principles and agenda-driven information can combine to lull consumers into false confidence, or an “illusion of knowledge.” Consumers make fund purchase decisions that disproportionately favor funds with recent good performance.[3] Real-time data obtained via the internet focuses attention on short-term performance – even on intra-day returns – which can lead to day trading and speculative trading.

Marketing and distribution efforts, fund family size, media coverage, and the spill-over effect to funds within the same family are factors that many consumers use to identify funds to purchase. Marketing and distribution costs (denoted by 12b-1 fees and commissions) reduce consumer search time and effort but increase internal fund fees. Research has shown that firms that have both high performance and extensive marketing efforts achieve twice the flows from consumers as their competition does.[4] Additionally, research has demonstrated that mutual funds with high marketing costs, offered through brokerages, underperform even prior to deducting fees, confirming that heavily marketed funds are not the top performers.[5]

Other factors that influence consumer purchases may include the size of the firm associated with the fund or the amount of media attention the fund receives. It has been shown that funds at larger firms grow quicker than funds at smaller firms, regardless of performance.[6] Increases in funds at larger firms are most likely due to increased conveniences, such as the ability to switch to other funds within the family. The observed tendency of investors to move within fund families supports this hypothesis.

Research showed that consumers base fund purchase decisions disproportionately on good recent performance. They flock to high-performing funds but then fail to flee low-performing funds at the same rate, perhaps because they are afraid to recognize losses. Chasing returns after the fact and holding onto losses are usually not good strategies and may negatively impact the growth of a portfolio. A better strategy might be to position assets in funds that are poised for growth.

The deluge of advertising, media “advice,” and salesperson solicitations consumers endure confuses decisions on selecting funds. Consumers gravitate to high performance driven by high marketing costs, but an alternative is to employ an advisor. All investors are prone to behavioral mistakes, but individuals without strong financial literacy are most vulnerable. There is a growing body of evidence of a positive relationship between financial delegation and increased risk-adjusted returns. If investment decisions are delegated, costs remain in the form of sales commissions, transaction costs, advisory fees, and time-search costs (particularly the time spend in gaining trust in an advisor). There may also be indirect costs stemming from a conflict of interest embedded in a business model where the advisor is not behaving as a fiduciary. An advisor who is a fiduciary – focused on the client’s comprehensive long-term goals – may do a better job in fulfilling client investment needs than a commission-driven agent. Overall, research reveals that consumers with more education, income, and net worth – characteristics that imply greater financial literacy – have a higher tendency to retain the services of a financial advisor.[7]

At Cumberland Advisors, we offer strategies based upon sound research and cost-efficient management. Consumers don’t pay commissions, 12b-1 fees, or loads. We do not heavily market our strategies but instead focus on providing responsible management and transparency. We support and encourage financial literacy. It’s the right thing to do for our clients and for the community in which we live.