Objective mutual fund performance studies have shown time and again that passive, indexed mutual funds beat their more expensive actively-managed cousins.
However, only about 10 percent of the assets invested in mutual funds has gone into passive, indexed funds. The vast majority of individual investors’ money has gone into funds that actively pick and choose which investments to buy based on the fund manager’s outlook for the economy, the markets, and individual industries and companies.
Two German university professors, Sebastian Müller and Martin Weber, researched this question and came to the following conclusion:
“Given the limited value that these funds seem to offer to their shareholders and the size of the fees they charge, current academic wisdom suggests implementing a simple passive investment strategy based on well-diversified, low-cost fund alternatives.”
I have seen this conclusion by numerous U.S. based investment researchers. But this is the first time I have seen this research from overseas.
These two German professors studied 3,000 mutual fund investors to see if there was any relation between investors’ financial literacy and their purchase of index funds or actively managed mutual funds. They expected that investors who had lower financial literacy would be influenced by salespeople and advertising to buy active funds.
They were surprised to find, however, that although financially literate investors were more aware of the advantages of passive indexed funds, the majority continued to put their money into active funds.
One possible explanation lies in what these two professors called “the overconfidence phenomenon.” It appears investors tend to overestimate their own ability to identify high-performing funds or high-performing managers.
But since active funds do not tend to do better than passive funds, these sophisticated investors in essence outsmarted themselves by being overconfident. They purchased actively managed mutual funds that overall had lower performance than their index mutual fund counterparts.