A new study conducted by a group of university researchers suggests that the average investor does not understand the impact of mutual fund fees on investment returns, and is confused by excessive prospectus information.

Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds was released Tuesday. Authors James Choi of the Yale School of Management, David Laibson of Harvard University, and Brigitte Madrian of Wharton Business School used MBA and undergraduate students from Ivy League universities as subjects.

"The subjects were asked two financial literacy questions from a John Hancock survey, which allowed us to compare their answers to a national population," explained Choi. Having determined the subjects had a greater level of financial literacy than the average investor, the researchers divided them into two groups, and asked them to allocate $10,000 across four front-load index funds tracking the S&P 500. One group received fund prospectuses for each of the four products, while the other group received both a prospectus and a one-page summary of each fund's fees.

Of those those that received the prospectus only, 81 percent of MBA students and 90 percent of undergraduates failed to minimize fees by allocating the entire amount to the cheapest fund. Many weighed irrelevant information, such as comparative performance since fund inception when the funds' lifetimes spanned different periods.

Even among those students provided with a straightforward list of fund fees, only 20 percent invested their entire allowance in the index fund with the lowest fee. Such results occurred despite the fact that the MBA students rated fees the most important factor in allocating a portfolio.

Undergraduate subjects rated fees the eighth most important consideration.

"The results imply that many investors don't understand that mutual fund fees are important and therefore don't search for the fee information in the prospectus," concluded Choi. "Those who claim to understand the importance of fees often can't accurately identify the fee information in the prospectus or may not know how to use it."

However, investors choosing high-fee funds seem to sense that they have more to lose. Those that chose funds with highest fees reported lower confidence and greater inclination to change their portfolio in response to professional investment advice.

Choi pointed out that the findings highlight a possible area on which policy makers might focus in drafting regulations. "If many investors are not paying attention to mutual fund fees, it may be important to create incentives for intermediaries like 401(k) and 529 college- savings administrators to pay attention for them," he said. "If important information such as a fund's fees were required to be transparent rather than being buried in a long prospectus, investors may be more likely to reallocate investments to lower cost funds." 

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