Imagine that you’re searching for a new car. And you’ve found two cars from different manufacturers that are effectively the same in terms of fuel efficiency, horsepower, and style. But one costs $20,000, and the other costs $200,000. Which car would you buy?
You may be thinking, “Why would anyone pay 10 times more for a car when there is a cheaper, almost-identical alternative on the market?” It seems irrational, right?
Traditional economics upholds that in a perfectly rational world, supply and demand determine an appropriate price point for equivalent goods or services. If the price exceeds what people are willing to pay, they will avoid the good or service. That typically results in an excess supply and, eventually, a lower price. But if a price is too low, customers will flock to that good or service, and there will be a shortage and a higher price. This supply-and-demand mechanism prevents large price disparities among nearly identical items.
Nearly identical index funds carry different fees
Yet, we’ve seen notable and persistent price disparities among U.S. equity index funds since 1990. It’s a puzzling phenomenon, given that the funds are so similar.
For example, a study on index fund fees showed that there are large levels of fee variation among S&P 500 index funds that are virtually identical in most relevant characteristics. RYSPX and SWPPX, for instance, are two S&P 500 index funds with a holding similarity score of 99.99 percent.
Over the past 20 years, based on current fees, if you had invested $10,000 in RSPYX you would have paid $4,475.32 in total fees. On the other hand, if you had invested $10,000 in SWPPX over the same period, you would have paid $101.30 in total fees. This massive difference cannot be attributed to differing underlying characteristics, because the two funds share almost identical portfolios.
So, how can such a large difference in fees persist across index funds that invest in the same underlying stocks, in the same manner, and thus provide nearly identical returns for investors? One possible answer is that the index fund fees are somehow obscured, and investors are not actively aware of them. Other clues can be drawn from behavioral economics: Consumers do not always act rationally, and they are prone to behavioral biases.
A behavioral glimpse into how investors compare index fund fees
There are two competing behavioral theories for why consumers often act irrationally when it comes to pricing. The value theory maintains that a lower price suggests to consumers a good value, or a sense of “more bang for your buck.” The quality theory, on the other hand, holds that consumers often assume that a higher price indicates better quality and better long-term return on investment.
A group of behavioral researchers ran a series of experiments to test how either of these theories may present itself depending on how participants are primed.
In one experiment, participants were primed with the value theory by being shown an article from HGTV.com about hardwood floors in which the designer emphasized “more expensive does not always mean better. Take bamboo for example: It is cheaper than other exotic woods, but it is resistant to wear and very stylish.”
Other participants were primed with the quality theory. The designer emphasized that “price is a first indicator of quality. Take ebony, for example. It is more expensive than most exotic woods, but it is more resistant and has incomparable style.”
Those participants in the quality group evaluated their flooring more favorably when it was described as expensive. In contrast, those in the value group ranked products higher when the cost was lower.
Using these behavioral insights to compare index fund fees
It appears that the quality theory—in which consumers assume high price indicates high quality—is at least partially at work when it comes to fee disparities across index funds.
So, what can be done to help investors compare index fund fees and avoid falling prey to false signals of quality? Advisors can talk to their clients about how behavioral biases may be influencing their investing behavior. While investors may not always make rational decisions, advisors can use lessons from behavioral science to nudge them into healthier financial habits.