“Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds” Choi, Laibson & Madrian (2005)
In their decision making process investors give too much weight to past returns, a statistic with little predictive value, and too little weight to costs, a statistic with much predictive value. These issues are exacerbated when choosing between index funds. If past returns vary solely due to different fund start dates, and the two funds track the same index with little error, then only costs should be considered. Another paper covered on this blog showed that high-cost index funds persist in the market despite their guaranteed underperformance. This paper uses an experimental setup to test whether additional information disclosures can help investors make better decisions when choosing index funds.
The experiment had three between-participant conditions. All participants received four S&P500 fund prospectuses and had to allocate $10,000 between them. In one condition participants received additional fee information, including a translation of front-end loads and ongoing fees into their dollar cost. In another condition, participants received historical returns information which was negatively correlated with fee amounts (due to different start dates). Participants were incentivised by the chance of receiving one of their chosen funds’ returns from the next year. Additionally, the experiment removed the impact of fund services – a common justification for high-fee funds.
The experiment showed that clarifying fee information shifted participants’ choices towards low-fee funds compared to the control condition, although allocations to high-fee funds were still substantial. Given the high correlation between these funds this is a situation where diversification does no pay off. And giving additional returns information lead to a shift towards high-fee high-performance funds.
This latter result is perhaps not surprising, and demand effects could be cited for both of these findings, but why is clarifying cost structure having such a weak effect on participants’ behaviour? One thing the authors note, and that I readily agree with, is naïve diversification. When choosing between multiple funds investors tend to allocate their funds fairly uniformly, even if the funds are not different enough to provide any true diversification benefit. Redesigned the experiment, so that investors must allocate their funds to only one fund, or are choosing from only two funds, should increase the size of the effect. Evidence in support of this interpretation comes from the finding that high-fee subjects tend to me more doubtful about their portfolio allocations.