The Index Fund Rationality Paradox

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.

Keywords: Mutual funds, S&P 500 index

JEL Classification: G20