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Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds

Author Info

Listed author(s):
  • James J Choi
  • David Laibson
  • Brigitte C Madrian

Abstract

We evaluate why individuals invest in high-fee index funds. In our experiments, subjects each allocate $10,000 across four S&P 500 index funds and are rewarded for their portfolio’s subsequent return. Subjects overwhelmingly fail to minimize fees. We reject the hypothesis that subjects buy high-fee index funds because of bundled non-portfolio services. Search costs for fees matter, but even when we eliminate these costs, fees are not minimized. Instead, subjects place high weight on annualized returns since inception. Fees paid decrease with financial literacy. Interestingly, subjects who choose high-fee funds sense they are making a mistake.

(This abstract was borrowed from another version of this item.)

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Paper provided by David K. Levine in its series Levine's Working Paper Archive with number 122247000000002014.

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Date of creation: 21 Mar 2008
Handle: RePEc:cla:levarc:122247000000002014
Contact details of provider: Web page: http://www.dklevine.com/

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Find related papers by JEL classification:
  • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
  • D18 - Microeconomics - - Household Behavior - - - Consumer Protection
  • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - Oligopoly and Other Forms of Market Imperfection
  • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness

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  1. Xavier Gabaix & David Laibson, 2006. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," The Quarterly Journal of Economics, Oxford University Press, vol. 121(2), pages 505-540.
  2. Henrik Cronqvist, 2005. "Advertising and Portfolio Choice," CeRP Working Papers 44, Center for Research on Pensions and Welfare Policies, Turin (Italy).
  3. Susan E. K. Christoffersen, 2001. "Why Do Money Fund Managers Voluntarily Waive Their Fees?," Journal of Finance, American Finance Association, vol. 56(3), pages 1117-1140, 06.
  4. Carlin, Bruce I., 2009. "Strategic price complexity in retail financial markets," Journal of Financial Economics, Elsevier, vol. 91(3), pages 278-287, March.
  5. John Beshears & James J. Choi & David Laibson & Brigitte C. Madrian, 2011. "How Does Simplified Disclosure Affect Individuals' Mutual Fund Choices?," NBER Chapters,in: Explorations in the Economics of Aging, pages 75-96 National Bureau of Economic Research, Inc.
  6. Russ Wermers, 2000. "Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses," Journal of Finance, American Finance Association, vol. 55(4), pages 1655-1703, 08.
  7. Ippolito, Richard A, 1992. "Consumer Reaction to Measures of Poor Quality: Evidence from the Mutual Fund Industry," Journal of Law and Economics, University of Chicago Press, vol. 35(1), pages 45-70, April.
  8. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
  9. Lu Zheng, 1999. "Is Money Smart? A Study of Mutual Fund Investors' Fund Selection Ability," Journal of Finance, American Finance Association, vol. 54(3), pages 901-933, 06.
  10. Sendhil Mullainathan & Andrei Shleifer, 2005. "Persuasion in Finance," NBER Working Papers 11838, National Bureau of Economic Research, Inc.
  11. Edwin J. Elton & Martin J. Gruber & Jeffrey A. Busse, 2004. "Are Investors Rational? Choices among Index Funds," Journal of Finance, American Finance Association, vol. 59(1), pages 261-288, 02.
  12. Travis Sapp & Ashish Tiwari, 2004. "Does Stock Return Momentum Explain the "Smart Money" Effect?," Journal of Finance, American Finance Association, vol. 59(6), pages 2605-2622, December.
  13. Ali Hortaçsu & 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, Oxford University Press, vol. 119(2), pages 403-456.
  14. James J. Choi & David Laibson & Brigitte C. Madrian & Andrew Metrick, 2004. "Consumption-Wealth Comovement of the Wrong Sign," NBER Working Papers 10454, National Bureau of Economic Research, Inc.
  15. Sendhil Mullainathan & Joshua Schwartzstein & Andrei Shleifer, 2008. "Coarse Thinking and Persuasion," The Quarterly Journal of Economics, Oxford University Press, vol. 123(2), pages 577-619.
  16. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
  17. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, vol. 53(5), pages 1589-1622, October.
  18. Jonathan B. Berk & Richard C. Green, 2004. "Mutual Fund Flows and Performance in Rational Markets," Journal of Political Economy, University of Chicago Press, vol. 112(6), pages 1269-1295, December.
  19. Muriel Niederle & Lise Vesterlund, 2007. "Do Women Shy Away From Competition? Do Men Compete Too Much?," The Quarterly Journal of Economics, Oxford University Press, vol. 122(3), pages 1067-1101.
  20. Hendricks, Darryll & Patel, Jayendu & Zeckhauser, Richard, 1993. " Hot Hands in Mutual Funds: Short-Run Persistence of Relative Performance, 1974-1988," Journal of Finance, American Finance Association, vol. 48(1), pages 93-130, March.
  21. Henrik Cronqvist & Richard H. Thaler, 2004. "Design Choices in Privatized Social-Security Systems: Learning from the Swedish Experience," American Economic Review, American Economic Association, vol. 94(2), pages 424-428, May.
  22. Prem C. Jain & Joanna Shuang Wu, 2000. "Truth in Mutual Fund Advertising: Evidence on Future Performance and Fund Flows," Journal of Finance, American Finance Association, vol. 55(2), pages 937-958, 04.
  23. Brad M. Barber & Terrance Odean & Lu Zheng, 2005. "Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2095-2120, November.
  24. Xavier Gabaix & David Laibson & Hongyi Li, 2005. "Extreme Value Theory and the Effects of Competition on Profits," Levine's Bibliography 784828000000000656, UCLA Department of Economics.
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