The Myth of the Dumb Fund Investor

The myth about mutual fund investors goes like this:

1) Mutual fund investors are bad at selecting funds.

2) If investors were to hold index-only funds instead of the rotten funds that they choose, they would be far better off.

3) Thus, mutual fund investors are the dumb bunnies of the investment industry.

Through repetition, this myth has become powerful--such that fact-checking appears no longer to be required. For example, I recently read an abstract for an upcoming academic article. The abstract states that investors place "substantial amounts of assets into index funds charging high fees (over 2% per year)." I ran the numbers. The substantial amounts turn out to be 0.02% of industry index assets; 2 basis points is the percentage of the U.S. population that lives in Bayonne, N.J.

Actually, fund investors are good at selecting funds. The proof can be found by comparing the asset-weighted returns for a fund category in a given year against the equal-weighted returns for that same category. If the asset-weighted returns are superior, then investors have favored better-performing funds. If, instead, the equal-weighted returns are stronger, then investors purchased relatively poor funds.

(In conducting this test, I looked at the past 10 calendar years, counting all funds that existed for the calendar year at the time of the measurement. Thus, a fund that expired in 2004 would be included for the 2001, 2002, and 2003 data, but not the 2004 data. The 10-year annualized totals for the category averages were calculated by stringing together the calendar-year results.)