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The index fund rationality paradox

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  • Boldin, Michael
  • Cici, Gjergji
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    Abstract

    Mutual funds that track the S&P 500 are popular because they have significantly lower costs than the average, actively managed equity fund. However, a measurable number of investors select index funds with excessive fees and uncompetitive returns. We call this observation the Index Fund Rationality Paradox because it conflicts with the belief that index fund investors are making a rational, low-cost choice in their 'type of fund' decision. In our analysis of this paradox, we find that both retail and institutional index investors tended to make better choices in recent years, but the cost of poor choices among both groups continues to be significant. In fact, we are able to identify an arguably naïve group of retail investors that seem to be unduly influenced by brokers and financial advisors. These investors are largely responsible for the remaining paradox.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 34 (2010)
    Issue (Month): 1 (January)
    Pages: 33-43

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    Handle: RePEc:eee:jbfina:v:34:y:2010:i:1:p:33-43

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Equity mutual funds Index funds Fund management fees;

    References

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    1. Todd Houge & Jay Wellman, 2007. "The Use and Abuse of Mutual Fund Expenses," Journal of Business Ethics, Springer, Springer, vol. 70(1), pages 23-32, January.
    2. James J. Choi & David Laibson & Brigitte C. Madrian, 2010. "Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 23(4), pages 1405-1432, April.
    3. Ali Hortaç Su & Chad Syverson, 2004. "Product Differentiation, Search Costs, And Competition in the Mutual Fund Industry: A Case Study of S&P 500 Index Funds," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 119(2), pages 403-456, May.
    4. Francesco Corielli & Massimiliano Marcellino, . "Factor Based Index Trading," Working Papers 209, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
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    7. Daniel Bergstresser & John M. R. Chalmers & Peter Tufano, 2009. "Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 22(10), pages 4129-4156, October.
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    10. Chen, Chen & Chen, Rong & Bassett, Gilbert W., 2007. "Fundamental indexation via smoothed cap weights," Journal of Banking & Finance, Elsevier, Elsevier, vol. 31(11), pages 3486-3502, November.
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    13. Ferris, Stephen P. & Yan, Xuemin (Sterling), 2009. "Agency costs, governance, and organizational forms: Evidence from the mutual fund industry," Journal of Banking & Finance, Elsevier, Elsevier, vol. 33(4), pages 619-626, April.
    14. Morey, Matthew R., 2003. "Should you carry the load? A comprehensive analysis of load and no-load mutual fund out-of-sample performance," Journal of Banking & Finance, Elsevier, Elsevier, vol. 27(7), pages 1245-1271, July.
    15. Cao, Charles & Chang, Eric C. & Wang, Ying, 2008. "An empirical analysis of the dynamic relationship between mutual fund flow and market return volatility," Journal of Banking & Finance, Elsevier, Elsevier, vol. 32(10), pages 2111-2123, October.
    16. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, American Finance Association, vol. 52(1), pages 57-82, March.
    17. Friesen, Geoffrey C. & Sapp, Travis R.A., 2007. "Mutual fund flows and investor returns: An empirical examination of fund investor timing ability," Journal of Banking & Finance, Elsevier, Elsevier, vol. 31(9), pages 2796-2816, September.
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    Cited by:
    1. Klaus Grobys, 2012. "Active PortofolioManagement in the Presence of Regime Switching: What Are the Benefits of Defensive Asset Allocation Strategies If the Investor Faces Bear Markets?," The Review of Finance and Banking, Academia de Studii Economice din Bucuresti, Romania / Facultatea de Finante, Asigurari, Banci si Burse de Valori / Catedra de Finante, vol. 4(1), pages 015-031, June.
    2. Adams, John C. & Mansi, Sattar A. & Nishikawa, Takeshi, 2012. "Are mutual fund fees excessive?," Journal of Banking & Finance, Elsevier, Elsevier, vol. 36(8), pages 2245-2259.

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