The title of a new article on Knowledge@Wharton caught my eye: “If Index Funds Perform Better, Why Are Actively Managed Funds More Popular?” Although multiple academic studies have found that index funds, which seek to match the performance of a broad market sector, consistently perform better than expensive actively managed funds where money managers try to beat the market, indexing (or passive management) accounts for only about 13% of assets in equity mutual funds.
Noting that most answers to the question, “Why do a majority of investors choose active management when passively managed funds perform better?” could be categorized under the umbrella “Investors aren’t very bright,” Wharton finance professor Robert F. Stambaugh in a paper entitled, “On the Size of the Active Management Industry,” co-authored with Lubos Pastor, a finance professor at the University of Chicago Booth School of Business, concludes that investors aren’t making foolish choices, but choose active management in a “kind of arms race to unearth a limited number of bargain-priced investments.”
“We wanted to come up with a rational explanation for why, despite this rather mediocre track record for active management, the lion’s share of money is still managed that way, as opposed to passively,” Stambaugh says in the article.
“If Index Funds Perform Better, Why Are Actively Managed Funds More Popular?” summarizes Stambaugh’s argument this way: “Investors’ rational belief that active managers have a better chance of sniffing out good deals if there are not too many managers looking. A rational investor will pull money out of actively managed funds if the results are disappointing, but he will not pull out entirely because he realizes that other investors will withdraw money, too. That will leave less money to chase the few bargains, making them easier to find.”
Acknowledging that industry marketing also has a hand in investors’ preferences, Stambaugh concludes, “There’s no reason to resort to calling investors stupid if you can explain [their behavior] without doing that.”