“Bargain Hunting or Star Gazing? Investors’ Preferences for Stock Mutual Funds” Wilcox (2002)
This paper compares the importance of management fees to other information that is important in fund choice, including company brand names and past returns. Somewhat unusually for a behavioural finance study this paper uses an experimental design (instead of being based on empirical data). It replicates two findings from the previous paper: that investors are responsive to front-end load fees (paid on purchase of the fund), but that ongoing management expenses are given little weight in the fund selection process.
Past returns are given the highest weight in this study, with their effect steadily increasing from one year to ten-years of data. An earlier study showed that diversification bias was much more prevalent when well-known assets have performed well. Could it be that a focus on past returns is driving the other biases? Diversification bias might be occurring when the first investment considered happens to have a high enough return that investors decide to “take the best” and make their decision based purely on that factor. Funds with especially high past returns are likely to also have high fees. This could be because of fund incubation, where fund families artificially inflate the average returns of their funds on offer by selectively picking funds that a high return before they were open for public investment. It could also be that actively managed funds have both higher average fees and a greater dispersion of returns than index funds. In that case a focus purely on past returns would move investors to high-fee funds.
Looking at front-end loads and ongoing management expenses, Wilcox finds that front-end loads are weighted with around twice the importance of ongoing fees. This is interesting, as from a rational perspective this would only make sense if investors’ expected holding periods are under two years! Although many investors do change their portfolios frequently, this is an extremely short period. The more likely explanation is that front-end loads are simply given far too high a weight, perhaps because they are more salient. Another explanation could of course be that investors place too much weight on the present relative to the future, as for example shown in hyperbolic discounting. The fact that ongoing expenses are underweighted in this controlled experimental study does at least suggest that this might be a separate bias to the chasing of high past returns.
The last curious relationship in this paper is an inverse relationship between financial experience and the weighting of these factors. More experienced investors in this experiment tend to place a greater weight on past returns relative to fees. This is interesting as it runs counter to the findings of a very large empirical study. One potential explanation is that the current study was fairly small, using only 50 participants. If that is the case, then it may fail to cover a full range of financial sophistication. A plausible hypothesis is that investors with a little bit, but not a great amount, of financial experience are the most likely to overweight past returns in their investment calculus. Of course the empirical study does have its own potential failings with the ever-present possibility of omitted variable bias. My tendency, however, would be to be in favour of those findings at least until the current study has been replicated.