Confusing disclosures and have complex fee structures make it challenging for investors to make wise decisions
While research by the Investment Company Institute shows mutual funds account for about 58% of retirement assets, making them a popular tool to spread investment risk, a new study suggests fund investors might not be effectively made aware of all the pitfalls in the products.
In the new study, "Obfuscation in Mutual Funds," MIT Sloan assistant professor of accounting Chloe Xie and her co-authors noted that despite their popularity, some studies show that mutual funds underperform benchmark portfolios. The literature also indicates that retail investors consistently make bad decisions when selecting funds, choosing high-fee funds even when similar low-fee funds are available.
The study found that complicated disclosures in mutual funds contribute to the issue by making it challenging for investors to make educated judgments. Given that many retail investors are making their own investing decisions, the Securities and Exchange Commission has previously voiced its concern that mutual fund disclosures need to be less opaque and contain more understandable language.
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To determine whether complicated writing and complex fee structures in disclosures could be blamed for investors' poor decision-making, Xie and her co-authors looked at narrative complexity in summary prospectuses and prospectuses for funds. They evaluated prospectuses based on metrics including:
- the number of distinct funds presented in a single prospectus;
- the extent to which the details section's terminology was duplicated in the prospectus summary, adding to the uncertainty;
- how many words were typically used in a sentence; and
- The length of the prospectus as a whole and the summary expenditure disclosure.
The number of share classes, charge kinds, and fee tiers for a given fund were used to quantify structural complexity as well.
The results found "strong and positive associations" between fees and narrative and structural complexity. The funds that had more structural complexity (complicated fee structures) and narrative complexity (less readable disclosures) were also the ones that charged higher fees, which may indicate that this complexity was intended to "obfuscate" high costs.
Given the strict regulations governing mutual fund disclosures and the widespread belief that investing in index funds is an inexpensive method to build a varied portfolio, the authors were particularly taken aback by the results.
To help reduce obfuscation, the authors suggested that authorities could simplify language, tighten regulation on fee structures, and increase advisors’ responsibilities when making recommendations across mutual funds from different companies.
Xie emphasized, however, pointing out that mutual funds are potentially just imitating what other financial intermediaries are doing in terms of complexity and costs, rather than consciously making disclosures confusing for investors. "Strategic behaviors could have evolved unintentionally," she said.
That said, the authors still saw “evidence consistent with fund managers’ not embracing the SEC’s efforts to reduce complexity in fund disclosures.”
Overall, “our results indicate that unreadable disclosures are part of a discretionary strategy to extract rents from retail investors,” they wrote.