The next time youÂ’re out on the golf course and your partner begins bragging about his hot-shot fund manager and his high return on investment, be skeptical. Be very skeptical.
That investor is probably better off in equity index funds, and his fund manager is likely to know it.
“I was clueless about this index fund vs. actively managed fund idea four or five years ago,” said Donald Lichtenstein, a professor in ¶¶Òõ¶ÌÊÓƵ-BoulderÂ’s College of Business and Administration. “Then I started reading and listening to good advice.”
His new study, conducted with ¶¶Òõ¶ÌÊÓƵ finance Professor Sanjai Bhagat and Georgia State Professor Patrick Kaufmann, is "Toward an Understanding of Inefficient Consumer Mutual Fund Investment Decisions: Implications for Public Policy." The report provides well-known reasons from the academic finance literature why investors should invest in index funds, and then the authors identify psychological and behavioral aspects that keep investors from doing the right thing.
“The data all support the notion that long-term investors continue to pour money into the actively managed equity mutual fund market, despite an abundance of empirical historical evidence that only a minority of fund managers outperform the market in a typical year – and fewer still achieve above-average market returns for their investors year after year.”
Investors who pay fees to portfolio managers for their assumed ability to "cherry-pick" equities for the funds they manage, are probably reducing the returns they could earn by simply investing in a passively, non-managed equity index fund that tracks the total market or some portion of it, such as the S&P 500.
The researchers offer a series of propositions for why investors continue to invest in actively managed mutual funds when the data suggest they are better off in a passive fund, based on findings from the psychological, behavioral finance, and consumer behavior literature.
"So many individual investors have no idea they're losing possibly hundreds of thousands of dollars," Bhagat said. "It begs the question of what aspects of the financial marketplace and which consumer traits are responsible for this phenomenon."
Although the market has outperformed most actively managed funds in recent years, a high percentage of new investment dollars are invested in actively managed funds, and most new investment dollars flow into actively managed funds.
Why do investors insist on paying fund managers when they are not getting what they pay for? Lichtenstein, Bhagat and Kaufmann identify 18 psychological and behavioral propositions they contend may help account for this situation.
"To label investors in actively managed funds 'fools' is perhaps a bit too pejorative, especially since I have made such investment choices in the past" says Lichtenstein. "Yet, given that many people earmark these investments for retirement, they would benefit by radically changing their investment strategy."
Given the magnitude of investor dollars flowing into actively managed funds (from 1980 to 1995 the number of mutual funds increased nine-fold from 564 to 5,761; the percentage of U.S. households participating in mutual funds rose from 6 percent to 31 percent; and total mutual fund assets soared from $135 billion to approximately $2.8 trillion), the professors hope federal regulatory agencies and employers who sponsor retirement plans will undertake investor education programs.
"The need for such measures seems immediate," the study concludes. Lichtenstein says that steps need to be taken to create some level of awareness of the merits of passive investing or investors increasingly will be injured.
With stock market indexes reaching new highs, these propositions may serve as a red-flag warning investors.
Following are some of the behaviors believed to explain why investors use actively managed, instead of passive, funds:
• Lack of knowledge: Many investors are unaware that the average market return is often the appropriate reference point to use when evaluating actively managed mutual fund returns.
• Broker's influence: In light of the complexity of the market, some investors "blindly" follow the advice of their broker. Because selling passively managed index funds is far less profitable to brokers than managed funds, there is a strong financial incentive to push managed funds.
• Discomfort with “average” returns: Investors interpret average returns as sub-standard. Average returns are what passively managed index funds produce, so some people choose to take a chance at higher market returns produced by some – but relatively few – actively managed funds.
• Investor confidence: Active investors also are more likely to believe that the ability to pick high performing stocks reflects a skill, and hence, are more prone to attempt to master the market by beating the odds instead of playing the odds.
• Influence of past performance: The financial media run articles devoted to rating the best and worst performing mutual funds. Such ratings, which are based on past performance, have little predictive value, yet consumers often rely on them because they believe these funds will continue to perform well in the future.
• Price: Many investors do not factor in – or don’t even know – fund costs when making investment decisions. Estimates of the difference in cost between actively and passively managed funds fall in the range of 1.7 percent. The difference represents the margin managers must add to the performance of their funds in order to break even with passively managed funds.
• Business publications: Investment magazines and newspapers perpetuate the so-called “need” to use managed funds. If everyone used index funds, there wouldn’t be a need for these publications.
• The search for perfection: Some investors think they can beat the market. Some can. But in the long run, index funds will make them more money.