Financial Products: The Less You Understand, the More You Pay

“Life is not complex. We are complex. Life is simple, and the simple thing is the right thing.” (Oscar Wilde)

Unit trusts are meant to be simple. They should be a straightforward and cost-effective way to invest in financial markets.

Unfortunately, however, the financial services industry has a long history of being neither of those things.

Some of it is self-serving. Some of it has been due to regulation. But many firms make things unnecessarily complex. And expensive.

Obfuscation

A recent research paper by academics at the University of Washington, MIT and the University of Pennsylvania highlighted how this has implications for investors.

In the study titled “Obfuscation in Mutual Funds”, the researchers wanted to see whether there was a link between how complex fund documents were and the fees those funds charged.

What they found is telling: funds with more complex material also have higher fees. And, therefore, worse returns.

This suggested that fund managers use this complexity to “obfuscate” high fees. This is not necessarily deliberate. It may just be behaviour that has evolved over time. But it is significant.

The researchers also found an interesting link with how products are marketed. The more that fund companies market their products, the more likely those products are to have complex documents.

Which, of course, means higher fees.

They make the interesting point that marketing is likely “to be more effective when investors are uninformed”.

It gets worse

These researchers were just looking at unit trusts, but their findings are relevant for all financial products. And unfortunately there have been some particularly bad examples of how investors have fallen foul of products that are overly complex, or with material that isn’t well explained.

The less investors understand, the more firms can get away with.

Issues such as graphs with no headings, complicated write-ups about how the fund invests, convoluted explanations for where returns come from, and elaborate structures easily cause confusion.

In some instances, it does seem like there are firms that deliberately set out to mislead. Inevitably, they will do this by adding complexity. When something is simple and easily understandable, that is more difficult to do.

This highlights an important truth for investors: the less you understand about a product, the more you are likely to end up paying for it, and the more likely it is that you are being misled.

Fortunately, once you know about it, it’s an easy trap to avoid. If you don’t understand how a product works, what its strategy is, what the outcome is likely to be, and exactly what fee you will be paying, look elsewhere. By doing so, you will probably save yourself a lot of money.

To review the financial products you are using, speak to a professional.


Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.

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