Are Investors Rational? Choices Among Index Funds

NYU Working Paper

35 Pages Posted: 8 Nov 2002

See all articles by Edwin J. Elton

Edwin J. Elton

New York University (NYU) - Department of Finance

Jeffrey A. Busse

Emory University - Department of Finance

Martin J. Gruber

New York University (NYU) - Department of Finance

Multiple version iconThere are 3 versions of this paper

Date Written: June 2002

Abstract

Financial theory is often based on the belief that the actions of rational investors determine prices, which leads to the elimination of dominated financial instruments. Recently a series of articles have been published which question the rationality of investor behavior. Standard and Poor's 500 index funds represent one of the simplest vehicles for examining whether investors make rational decisions consistent with the normal paradigm of financial economics. S&P 500 index funds hold virtually the same securities, yet they differ by more than two percent per year in the fees they charge investors and the returns they offer investors. In this paper, we show that the relative returns offered by alternative S&P index funds are easily predictable. We show that the other important aspects of performance, risk and tax efficiency, are also easily predictable. Despite this predictability, the relationship between new cash flows and performance is much weaker than we would expect based on rational behavior. Marketing and spillover account for some, but only a small amount, of the cash flows not accounted for by performance. We show that selecting funds based on low expenses or high past returns leads to a portfolio that outperforms the portfolio of index funds selected by investors. Our results exemplify the fact that, in a market where arbitrage is not possible, dominated products can prosper.

Keywords: rationality, index funds, mutual funds

JEL Classification: G12, G14

Suggested Citation

Elton, Edwin J. and Busse, Jeffrey A. and Gruber, Martin J., Are Investors Rational? Choices Among Index Funds (June 2002). NYU Working Paper. Available at SSRN: https://ssrn.com/abstract=340482 or http://dx.doi.org/10.2139/ssrn.340482

Edwin J. Elton (Contact Author)

New York University (NYU) - Department of Finance ( email )

44 West 4th Street
Ste 9-190
New York, NY 10012-1126
United States
212-998-0361 (Phone)
212-995-4233 (Fax)

Jeffrey A. Busse

Emory University - Department of Finance ( email )

Atlanta, GA 30322-2710
United States
404-727-0160 (Phone)
404-727-5238 (Fax)

Martin J. Gruber

New York University (NYU) - Department of Finance ( email )

44 West 4th Street
Ste 9-190
New York, NY 10012-1126
United States
212-998-0333 (Phone)
212-995-4233 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
3,076
rank
3,186
Abstract Views
11,692
PlumX Metrics
!

Under construction: SSRN citations while be offline until July when we will launch a brand new and improved citations service, check here for more details.

For more information