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OPINION

Buying bad funds

Buying bad funds
January 7, 2014
Buying bad funds

Jill Fisch and Tess Wilkinson-Ryan at the University of Pennsylvania ran experiments in which they asked subjects to choose among 10 hypothetical funds as if they were investing for 30 years; the funds were chosen so that some charged higher fees than others. They found that most people spread their money across most funds, even though the low-fee funds were obviously superior. And they continued to do so even when told that fees matter enormously for long-run returns, and were given clear information about funds' charges. Nor did that information cause a shift out of expensive actively managed equity funds into trackers.

Good information, then, isn't sufficient to lead to good investment choices.

What's going on here is a framing effect. The menu of options influences our choices among those options, so we tend to choose inefficient funds simply because they are there. This corroborates a famous finding by Shlomo Benartzi and Richard Thaler. They found that when intelligent people saving big money for their retirement - teachers and pilots - were offered a choice among lots of bond funds and few equity funds, they invested more in bonds than equities. But when they were offered a few bond funds and many equity funds, they invested more in equities.

It's quite likely that Fisch and Wilkinson's laboratory evidence applies to the real world. Actively managed funds outnumber tracker funds, and are more heavily advertised, and this alone increases our tendency to buy them. The message of this, conclude Messrs Fisch and Wilkinson, is that investor choice "does little to protect investors or to produce efficient investment decisions".

There is a cure for this bias - to change our frame. We should think of the default option for equity investment as an All-Share tracker fund; this is, in effect, a low-cost investment in all UK equity funds. We should deviate from this default position only if we have good reason to do so.

There is, though, another bias at work here. Professors Fisch and Wilkinson asked subjects to consider two funds both of which offered 8 per cent annual returns before fees where one charged 1 per cent per year and the other 2 per cent. They asked: over 30 years, how much difference would fees make to your final wealth with a $10,000 initial investment? The median answer was $3,000. But the correct answer is $18,685. Subjects horribly underestimated the impact of fees.

This is an example of the anchoring effect; we think 1 per cent is a small sum, and fail to see that it compounds a lot over time.

Now, you might think that you know enough to avoid these errors. So you should; anchoring and framing are among the most well-known cognitive biases. Such a belief, however, leaves us vulnerable to a third error - that of overconfidence. Economists at Mannheim University have found that even the savviest investors hold lots of poor performing high-cost funds. One reason for this, they say, is that smart investors overestimate their chances of spotting good funds and so pay too much in fees to bad funds.

None of this is to say that actively managed funds are all useless. It just means that demand for them might be inflated by some simple errors of judgement.