Fee Complexity and Investor Mistakes in Retail Financial Markets

Abstract

Mutual funds sold via brokers offer fund portfolios that investors can purchase in one of three classes: A, B or C. These classes are distinguished only by their fee schedules and thus have different net performance results. An analysis of relative class performances for a set of U.S. mutual funds between 1992 and 2008 reveals a striking fact about class B: while classes A and C provide the best performance results at long and short holding periods, respectively, class B is dominated by either class A or C at any holding period. The inferiority yet popularity of class B at first suggests that naïve investors who do not understand the fee schedule of this class are being exploited. However, I propose two hypothetical clienteles which might rationally demand class B shares: one (a) with uncertain holding periods, or one (b) that desires to have long holding periods but is unable to commit to them. I identify whether investors rationally or naïvely purchase class B by examining the flow-fee sensitivity and estimating investor holding periods. My results support the naïve investor explanation.