The Index Fund Rationality Paradox and Categorical Thinking

During the last twenty years, literature has emerged exploring why individuals invest in high-fee index Mutual Funds (MF) while there are funds tracking the same index and charging remarkably lower commissions. This paper puts forward the individuals’ tendency to categorical thinking as one of the driving forces of this ‘index fund rationality paradox’. The main hypothesis is that individual investors do not recognize the difference between active and passive (index) funds and presume that relatively high fees, adequate for heterogeneous and costly active funds, are also acceptable for low-cost homogeneous index funds. I test this hypothesis using a survey-based experiment, conducted among the first-generation High Net Worth Individuals (HNWI) and economics and finance students from leading universities. The obtained results show that, indeed, the vast majority of respondents fail to distinguish clearly the active and the index funds: they confuse their objectives and activities, misperceive the skills and efforts required to manage different types of funds. On the other hand, the average answers reveal that some comprehension of the difference between various types of funds is present: on average, the participants attribute higher skills and efforts to the managers of active funds, and are ready to pay higher fees to them. Based on these findings, I formulate basic problems that should be addressed by new policies aiming to minimize the negative effect of categorical thinking on investment in mutual funds.