FIN-02-045 |
NYU Stern School of Business |
Are Investors Rational? Choices Among Index Funds
October 2002
Edwin J. Elton, Martin J. Gruber and Jeffrey A. Busse
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.
Edwin J. Elton
Institution: Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012
Telephone: (212) 998-0361
Fax: (212) 995-4233
Email: eelton@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~eelton
Martin J. Gruber
Institution: Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012
Telephone: (212) 998-0333
Fax: (212) 995-4233
Email: mgruber@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~mgruber
Jeffrey A. Busse
Institution: Assistant Professor of Finance, Goizueta Business School, Emory University.
To download a copy of this paper click here
To request a copy of this paper click here
|