An Empirical Study on the Cost of Institutional Boundaries and Lacking Financial Sophistication in the Mutual Fund Selection Process

Abstract:     
This paper contributes to the growing body of literature on private investors' investment mistakes in household finance. This paper takes off from the point that investors abstain from chasing alphas in selecting mutual funds, although Gruber (1996) has proven this to be a profitable strategy. He argues that reasons for this behaviour might be lack of investors' sophistication and/or institutional boundaries. Based on a survivorship bias free database of almost 3,000 mutual funds in 6 peer groups, this paper presents two main findings. Firstly, the difference between a sophisticated investor who chases past alpha performance and an unsophisticated investor who chooses a fund randomly is 2.9% p.a. expressed in alpha in the absence of institutional boundaries and 1.3% p.a. in their presence. Costs of institutional boundaries are only of economic relevance for sophisticated investors. In that case, the alpha performance is about 1.6% p.a. larger than in the presence of institutional boundaries. Secondly, we show that applying the newly proposed "Alpha Persistence Ratio" (APR) increases the annual alpha by 0.9% compared to an institutionally unbounded alpha chasing strategy.

Number of Pages in PDF File: 29

Keywords: Cost of investment mistakes, Mutual Funds, Fund performance, Fund selection criterion

JEL Classification: G11, G23

working papers series