Academic journal article The Journal of Consumer Affairs

Why Consumers Choose Managed Mutual Funds over Index Funds: Hypotheses from Consumer Behavior

Academic journal article The Journal of Consumer Affairs

Why Consumers Choose Managed Mutual Funds over Index Funds: Hypotheses from Consumer Behavior

Article excerpt

Much evidence exists which suggests that the vast majority of equity mutual fund managers do not possess differential information (or skills) which allow them to achieve above average market returns for their investors. Thus, when investors pay fees to equity mutual fund managers for investment advice and management, the very probable outcome is that they are reducing the return that they would otherwise achieve by investing in a nonmanaged index fund that tracks the total stock market (e.g., Wilshire 5000) or some significant portion of it (e.g., the Standard & Poor's 500). The long-term negative consumer welfare implications are large, very possibly in the hundreds of thousands of dollars for individual consumer investors. Drawing largely on insights from the psychology, consumer behavior, and behavioral finance literatures, we offer a series of hypotheses that may partially account for such consumer choices. We conclude with a call for increased government- and employer-sponsored education programs aimed a t creating a more informed consumer investor.

In a market economy, differences in brand choice across consumers may reflect differences in individual tastes and preferences and/or differences in information. While this is relatively straightforward conceptually, in many consumer markets it is difficult to disentangle differences in individual tastes and preferences from differences in information. For example, would a consumer purchasing a particular brand of running shoe that has a relatively high price to quality ratio (as ranked by some independent rating service, e.g., Consumer Reports) be reflective of a lack of information or a manifestation of individual taste and preferences based on full information? An answer to this question would be difficult to infer. However, making this inference is less problematic in market situations where one of these two factors (consumer information or individual taste and preferences) can be assumed to be constant.

It appears plausible to argue that one such situation where taste and preferences may be assumed to be constant across consumers may be the market for equity mutual funds for long-term investors. Virtually all consumers in this market desire investments which have the highest probability of maximizing dollar returns over the life of the investment for some given level of risk. Consequently, to the extent that investments in alternative equity mutual funds provide predictably different levels of risk-adjusted long-term returns, consumer purchase of a lower yield investment would appear to reflect differences in information, and thus, a poor choice. The preponderance of evidence reported in both the academic finance literature and popular business press indicates that many consumers are making such poor choices. That is, most consumers are choosing to invest in managed mutual funds rather than index funds despite strong evidence that the latter type of fund provides a predictably higher level of risk-adjusted return, usually by margins exceeding a full percentage point.

Because of the effect of compounding on returns, the consumer welfare implications of such a margin are very large. For example, given an initial $10,000 investment held for a period of 10/20/30/40 years, the difference in wealth accumulation between a 10 percent and 11 percent return is approximately $2,500/$13,300/$54,400/$197,400, respectively. Given that, for many consumers, the dollars earmarked for retirement will greatly exceed $10,000, will often be held for periods exceeding 40 years, and will be invested in managed funds that predictably underperform comparable (or lower) risk index funds by margins that usually exceed 1 percent, the negative consumer welfare implications are often more severe than that depicted in this illustration. That these consumers are making poor choices has enormous implications for consumer welfare and begs the question: What aspects of the financial marketplace and which consumer traits are responsible for this situation? …

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