How wary are Indian investors of figuring out what they pay in making their investments? And how agile are financial firms in taking advantage of their errors? It is difficult to answer these questions convincingly, unless one can find situations that clearly isolate the fee effects. Two Wharton professors, Santosh Anagol and Hugh Kim, do just that and uncover some interesting facts in their recent working paper.*

The regulation of the fee structure underwent several tweaks and experiments even before Sebi did away with entry loads completely in 2009. Before 2006, for instance, both open-ended and closed-ended funds (strictly speaking limited liquidity funds, since their subscribers can get in or out in certain restricted time windows) were allowed to charge entry fees and initial issue expenses up to 6% each of initial investment, in addition to an expense ratio of a maximum of 2.5%. This changed on April 4, 2006. It was then that Sebi mandated that while open-ended funds could charge only ?entry fees?, closed-ended funds could charge only ?initial issue expenses?. Both entry fees and issue expenses had a ceiling of 6%, but with an important difference. While entry loads were to be charged in one go, and showed up in the very first monthly statement of the fund, the initial issue expenses could be amortised, that is, spread out, over the life of a fund?typically three years in India, after which most closed-ended funds convert to open-ended funds.

This difference was eliminated about 22 months later, on January 31, 2008, after which the closed-ended funds could no longer charge initial issue expenses but had to move over to entry loads like their open-ended counterparts.

These 22 months of fee differentials between open-ended and closed-ended funds produced interesting results in terms of both fund flows and the start of new funds. For equity funds, closed-ended funds registered an average monthly inflow going up from virtually zero prior to 2006 to over $14 billion a month in 2006, doubling to over $28 billion in 2007 and exceeding $20 billion in 2008, before going back to zero once again in 2009. In the two latter years, these figures exceeded those for the open-ended equity counterparts. For equity funds at least, the closed-ended funds seemed to owe their existence only to their ability to give the fee a different name and to amortise it, something open-ended funds could not.

Clearly then, investors were hoodwinked by the simple fact that they did not have to pay the fees in a single painful instalment but could just spread it out. Is this rational? No way. The discount factor necessary to justify this would be close to 800% a year! This is clear evidence of a perception error driving the entire industry. The error is compounded when one recalls that the closed-ended funds usually charged the full 6% of issue expenses allowed, while open-ended funds generally charged either a much lower 2.25% or, in many cases, waived the entry fee altogether, bringing the average entry fee to only 1.75%. Closed-ended funds also performed considerably worse than open-ended funds in terms of returns.

Did fund companies realise this and step in to cash out from this opportunity? You bet. Closed-ended funds really came to life during those 22 months of opportunity. Before 2006 and after February 2008, there were practically no new closed-ended funds at all. But during the period of fee differential, over two new closed-ended funds were being started every month. In the last month, just before the window of opportunity closed, more than 10 funds were floated?the maximum fund starts in all times!

It took just a different name for the fee and spreading it over time to get Indian investors to believe they were getting a better deal when they were actually paying more for their investments.

There is little to suggest that such errors in treating fund fees are universal. In fact, experiments conducted by other researchers on American subjects have often demonstrated that framing effects on fund fees have little role in determining fund choice. Other evidence in the literature is open to alternative explanations. The current paper makes use of the policy changes to present the case in sharp relief. Investors, at least in India, cannot read the fine print when deciding on fund choices. Whatever Sebi?s rationale for these policy changes may have been, this almost incontrovertible lesson is certainly a positive outcome. One can only wonder if it balances the millions inadvertently lost in fees by the closed-ended fund investors.

* Anagol, Santosh and Hugh Kim, 2010, ?The Impact of Shrouded Fees: Evidence from a Natural Experiment?, Working Paper, The Wharton School, University of Pennsylvania

The author teaches finance at the Indian School of Business, Hyderabad