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http://hdl.handle.net/2451/26489
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| Title: | Are Investors Rational? Choices Among Index Funds |
| Authors: | Elton, Edwin J.
Gruber, Martin J.
Busse, Jeffrey A. |
| Issue Date: | Oct-2002 |
| Series/Report no.: | FIN-02-045 |
| 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. |
| URI: | http://hdl.handle.net/2451/26489 |
| Appears in Collections: | Finance Working Papers
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