A large group of academics believe that the stock market is about as predictable as a roulette wheel. There’s little point in trying to beat the market, they claim, because it just can’t be done on a sustainable basis — particularly when you add in fees.

Why, then, do investors continue to support higher-fee funds despite evidence that lower-fee, passive alternatives offer higher returns over the long run? Because they can’t quite figure out what those fees are nor can they gauge their impact, suggest researchers Wharton professor Brigitte Madrian; James Choi, a professor of finance at Yale; and Harvard professor David Laibson in their joint paper, Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds.

To prove their case, the researchers asked test subjects to choose from among a variety of index-style funds with identical stock holdings but different fees.

All participants were asked to make hypothetical investments of $10,000, choosing from among four funds.

Participants were told that at the end of the experiment, one of them would be randomly selected to pocket any profits, giving them an incentive to construct the most effective portfolio possible.

Although all participants were given fund prospectuses, one group also received a fee sheet detailing the fees charged by each of the four funds. Instead of this fee sheet, a second group received a returns sheet outlining each fund’s returns since inception, net of fees. Since the four funds’ portfolios were identical, returns varied only because the funds’ inception dates were staggered, covering different market periods.

With the four funds holding the same securities, their past performance was clearly irrelevant. Therefore, the logical choice had to be the fund with the lowest fees. Despite this, the mean fee of the participants’ choices was 1.2% higher than it needed to have been.

In addition, most people redundantly spread their money among two or more funds, despite the fact that they were all the same.

Results were the poorest for those given the returns sheet instead of the fee sheet, even though all the fee data was still available to them in the prospectuses.

Clearly, this group had used its information improperly, inferring a specious relationship between past and future performance and ignoring costs. And this buying pattern exists in the real world as well, further fuelling the argument supporting indexing.

In a 2004 paper, entitled Mutual Fund Flows and Performance in Rational Markets, Jonathan Berk, a finance professor at the University of California at Berkeley, and Richard C. Green, an economist at Carnegie Mellon University, served up a simple economic model to explain why investors consistently chase returns despite the fact that most money managers regularly fail to outperform passive portfolios and that mutual fund performance in general lacks persistence.

Both marketing and intuition encourage investors to move cash into funds that have seen the best performance. However, this creates a dilemma for money managers, the authors say.

Some money managers are talented enough to outperform the market if their portfolios remain small. But this isn’t sustainable from a business point of view, as fund companies are fuelled by growth. As a result, investors become more aware of a top manager’s talents, pouring money into his or her funds and, at the same time, muting performance, the authors maintain.

Berk, along with University of Exeter professor Ian Tonks, revisited this topic in a more recent paper, entitled Return Persistence and Fund Flows in the Worst Performing Mutual Funds, in which he argues that most investors should probably opt for index funds. And, if they do patronize actively managed mutual funds, they have to be willing to rotate them pretty often to avoid the real dogs. IE