Pay for Performance? Marketing Mutual Funds for Investors and Not Managers
The current marketing strategy of mutual funds hurts investors. An achievable set of actions by the Securities and Exchange Commission could improve investors’ outcomes, fund performance, and market efficiency.
When investors buy a mutual fund, they pay fees called the expense ratio. This ratio is a fixed percentage, say 0.75%, of the assets invested in the fund. As a result, the total fees investors pay to a mutual fund are pegged to the size of the fund instead of to its performance and act as a risk-free payoff for funds and fund managers. This scheme incentivizes the fund’s management to increase the fund’s size rather than its performance. They do so by heavy marketing, as we explain next.
Ideally, a fund’s size should depend on it offering investors a combination of low fees and high returns thanks to the fund manager’s skill. Our co-authored research estimates, however, that marketing expenses play as important a role as either the fees or manager skills in affecting fund sizes. In fact, marketing expenses account for one-third of the total cost of active management in the mutual fund industry. The bulk of marketing expenses are eventually passed on to investors.
While a reasonable degree of marketing can better inform investors, such large marketing expenses raise this question: Is the industry spending too much in a marketing arms race?
This spending seems to have worried the SEC, which has considered putting stringent limits on marketing expenses. Such a move may remedy the symptom instead of solving the size-before-performance disease. Some economists believe that this incentive problem would be corrected over time by investors allocating capital to the funds that performed better in the past. These economists assume that the fund’s management, knowing of this investor behavior, will strive to improve fund performance to grow the fund’s size.
Practically, however investors face real limitations in their ability to allocate capital to the better funds. One issue is passivity; a large category of investors rarely adjust their allocation over time. Conversely, a second issue is over-active “return chasing” by investors. This group over-focuses on the very recent fund performance – and that information is a very noisy indicator for future performance. Our recent co-authored research indicates that return chasing is at least partly caused by the "hot hand bias" of investors who rush to buy hot winners – funds that just had increasing performance – and sell recent losers – funds that just had decreasing performance.
In fact, research shows that funds advertise to exploit the "hot hand bias" in investor behavior by touting past performance. Moreover, our recent coauthored research shows that investors fall prey to such ads, even though those ads include an SEC-mandated disclosure that past performance is no guarantee of future performance.
Echoing the SEC mandate, economic research has shown that past performance is only very weakly, if at all, related to future performance. This finding is partly due to two known phenomena. First, stock prices are hard to predict; short-term fluctuations in fund performance are often due to luck rather than skills of fund managers. Second, fund performance tends to decrease with fund size – trading strategies become less effective when applied to a larger asset base. So, good performance is hard to maintain in the long run as the fund size grows, unless with extraordinary skills of managers. As a result, actively managed funds rarely beat the market indices over the long run. After accounting for the current fees, the vast majority (>90%) of actively managed funds generate net returns no better than passive index funds.
While past research shows that 79% of funds use some internal links between their managers’ compensation and performance, more recent research suggests that these links tend to be very weak. Importantly, even with these internal incentives, funds are still getting a risk-free payoff while investors must bear the entirety of the risks due to fluctuating performance.
We recommend that the SEC study the following actions to remedy these problems:
First, the incentives of mutual funds should be strongly tied to performance. One way is to directly tie the fees that investors pay to performance. The fee can be pegged to a moving-average of performance over some long horizon with a ceiling and a floor for extreme performance (e.g., a S-curve). In general, performance-pegged fees not only ensure risk-sharing, but also help align marketing to performance. The better-performing funds will end up with larger budgets to market themselves to investors. As a result, investors are better informed of better funds.
Second, the current SEC-mandated disclosures need to be strengthened to effectively warn consumers against return chasing. Our coauthored research finds that effective disclosures require stronger and less ambiguous wording that the current one. The current required disclosure states a weak negation that past returns do not guarantee future returns. Instead, a strong disclosure such as “past returns cannot predict future returns” will work better.
Third, funds that tout past performance should have to non-selectively list both short-term and long-term performance (e.g., 1, 3, 5, and 10-year performance, if available) together with the performance of relevant index funds.
These changes may lead to better informed investors who are less inclined to falsely chase after hot hands; properly incentivized mutual funds; and, ultimately, a more efficient market.
About the authors
Dr. Max Wei is Assistant Professor at the USC Marshall School of Business.
Dr. Gerard J. Tellis is USC Neely Chaired Professor of American Enterprise, Director of the USC Marshall Institute for Outlier Research in Business, and Director of the USC Marshall Center for Global Innovation. He recently published How Transformative Innovation Shaped the Rise of Nations: From Ancient Rome to Modern America.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.