A few years ago, in look-ing at 52 index funds tied to the Standard & Poor’s 500 composite index over a period of several years, New York University professors Edwin Elton and Martin Gruber noted that many investors fail to recognize that some of these market-matching funds have high costs and uncompetitive returns.

As a result, even though index fund performance relative to a benchmark can be accurately predicted, investors don’t move money to funds with the lowest expenses and highest expected returns.

This is paradoxical, Elton and Gruber concluded, as it conflicts with the belief that investors — particularly those who are self-directed — are making rational choices when selecting funds.

In a more recent paper, University of Pennsylvania professors Michael Boldin and Gjergji Cici further explored whether investors make the best choices among index funds. Again, the decision shouldn’t be difficult because index fund returns are largely determined by easily predicted management expenses.

The commodity-like nature of index funds suggests price competition should be more evident than it is with actively managed funds. After all, passive fund managers aim not to beat their benchmarks or even actively managed funds but to mimic closely the benchmark performance, less expenses. Thus, fund expenses should be singularly important in explaining and predicting differences in index fund performance, the researchers argue.

However, this argument appears to be inconsistent with several trends in the fund industry. First, the U of P authors note, index and exchange-traded funds are growing faster than actively managed funds as more investors buy into the notion that active management is costly and that the majority of fund managers have trouble beating the market consistently.

Second, index funds offered by management companies with the lowest cost structures — specifically, Vanguard in the U.S. — have enjoyed the fastest asset growth. Vanguard gathered US$39.5 billion in new assets by mid-year, up 85% from last year’s levels. Vanguard’s flows have been boosted by its reinvigorated ETF platform, an increasingly popular option among passive investors.

Third, many fund companies have lowered the MERs of their index funds to attract investors — with a subsequent uptick in sales. This suggests that many investors are indeed attracted to lower-cost funds and are behaving rationally.

In their analysis of this paradox, Boldin and Cici argue that it’s important to distinguish between retail and institutional index products and recognize that different groups of passive investors face dissimilar choices when searching for funds.

In fact, they argue, index funds shouldn’t be treated as commodities. Institutional funds have lower expenses than the average fund, but they also serve large investors and impose large minimum initial investment requirements. As a result, smaller, retail investors are left to search out funds with higher expenses. Thus, their inability to take advantage of lower priced funds is not a sign irrationality but a lack of opportunity.

The authors conclude that a growing majority of index fund investors recognize the importance of fund expenses and do search for low-cost funds. By accounting for retail and institutional investor opportunity sets in creating benchmarks, the authors found that retail index funds as a group have become more efficient and competitive over time. While the paradox has yet to be solved, it has become less of an issue in recent years. IE