Are Investors Rational? Choices Among Index Funds

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.