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Why High-Cost Mutual Funds Persist

I recently found myself pondering a couple facts that seem odd in an industry as hypercompetitive as financial services:

  1. Average expense ratios for mutual funds (that is, the cost to shareholders–the customers) have steadily climbed (as a percentage, not just in dollar amounts) over the years.
  2. While most index funds offer very low expenses, there are still many that do not. In fact, some index funds even charge sales loads.

The question of index funds is particularly noteworthy to me. Given their identical portfolios, index funds are ostensibly a commodity, meaning there is no way to distinguish one from another except for cost. So why aren’t the high-cost ones pushed out of existance?

Thinking back to Econ 101

In microeconomics, the term “perfect competition” is used to describe a market in which producers/suppliers have no option as to what price they can charge. They cannot charge more than the market price for their product, otherwise buyers will simply buy from another producer.

So why isn’t this happening?

Well, let’s think back to Econ 101 and the requirements for a perfect competition market:

  • Many buyers and sellers: Yep! There are plenty of fund companies (sellers) and millions of investors (buyers).
  • Homogeneous products: Yep! For each S&P 500 index fund, the portfolio should be substantially identical.
  • Firms aim to maximize products: Yep! Not a lot of not-for-profits running mutual funds.
  • Perfect information: Ah ha! Here’s the problem.

Imperfect Information

In order for perfect competition to exist in a market, buyers and sellers must each have perfect information as to the price offered by each seller. And this, sadly enough, is far from the case in the field of investing.

Too many investors are entirely unaware of the price they’re paying for their funds. During my short time as a financial advisor, I was surprised by how many people I came across who were under the impression that the only cost of owning a mutual fund was the sales load. (And therefore, every no load fund was obviously free!)

Holy cow. What misinformation.

Of course, it’s easy to miss fund operating expenses. After all, they’re buried several pages deep in what has got to be the least appealing reading I’ve ever seen: Fund prospectuses. Is that accidental? I doubt it.

Would it be unreasonable to ask for regulations requiring more prominent placement of expense ratio information in fund sales literature? It certainly seems that it would be in investors’ best interests. After all, it’s difficult to make an informed buying decision when you don’t know the price of the product.

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  1. nice post today. asymmetrical information is definitely how these funds get away with essentially ripping people off.

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