Why do individual investors persistently pour their money into actively managed portfolios, when studies demonstrate they would be better off putting it in an index fund? According to the Investment Company Institute, a U.S. mutual fund industry trade group, passively managed accounts encompass only 13 percent of assets in equity mutual funds, even though index funds have been around for nearly 40 years. Even institutional investors, with a greater appetite for indexed returns, only commit from one-third to half their holdings to passive portfolios.
Researchers have been wondering about this for years. Some chalk it up to slick marketing, tax considerations, a tendency to hold out for countercyclical performance, or other factors unrelated to performance. A new study by two academics, Robert F. Stambaugh of the Wharton School and Lubos Pastor of the University of Chicago Booth School of Business, is the latest to tackle this paradox. They conclude that there’s nothing irrational in investors’ preference for active management.
Instead, they are reacting to a problem that affects the entire asset management industry: decreasing returns to scale. “Any fund manager’s ability to outperform a passive benchmark declines as the industry’s size increases,” they write in a working paper first presented late last year. “As more money chases opportunities to outperform, prices are impacted and such opportunities become more elusive.” ....