Why do people buy the equity funds that have the worst returns?
Economics researchers in Norway have come closer to an explanation to a major paradox.
Several studies have shown that for most people who save in equity funds, the best bet is to put their money in what are called passive funds.
So why do a clear majority of people continue to buy active funds?
Lots of money lost
The Norwegian Consumer Council has analysed the return on equity funds over the past 20 years.
If you invested your money in active funds, you would on average be left with a 1.1 per cent poorer result every single year compared to the stock exchange indices, the analysis showed.
That would be a lot of money lost over the years.
With your money invested in passive funds, however, the value of the fund would follow the stock market index.
Most people buy active funds
“It’s a losing proposition for a clear majority of people to buy an actively managed fund, compared to a passive index fund,” said economics researcher Ingar Kyrkjebø Haaland at the University of Bergen (UiB) to sciencenorway.no.
“The paradox is that the majority still choose to continue buying active funds,” he said.
Haaland and his colleague Ole-Andreas Næss from the Norwegian School of Economics (NHH) in Bergen wanted to know why this is the case.
They have a hypothesis, which is that many people who put their savings or pension money in funds simply aren’t aware of the most profitable way to invest their money.
“We have now conducted a survey among Norwegian fund customers, and it clearly points in the direction that our hypothesis is correct,” Haaland said to sciencenorway.no.
“There are substantial misconceptions among people regarding the most profitable options when it comes to active and passive funds,” he said.
“Many believe that active funds are the most profitable.”
Think they are smarter
When the researchers asked follow-up questions, they found that quite a few people believe that they themselves are best able to select which actively managed fund will do well on the stock exchange.
“This mainly is about them choosing an actively managed fund that has done well on the stock exchange in recent years.”
But even in this situation, many investors will be disappointed, the researchers found.
There is no connection between funds that have done well on the stock exchange in the last five years, and funds that have done well in subsequent years, according to the Norwegian Consumer Council.
Active and passive funds
Consumers can choose between two types of equity funds to invest in:
Active funds. Here you pay for stockbrokers to buy and sell shares on your behalf, with the goal of giving you the highest possible return on your money.
Passive funds — also called index funds. The price of these is on average only one-fifth of the price of active funds. These funds are driven by a computer that constantly copies the current selection of stocks in an index.
Source: The Norwegian Consumer Council / Finansportalen
People are open to knowledge
At the end of their study, the researchers wanted to explain to people about the difference between active and passive funds and their performance on the stock exchange.
“When people who wanted to buy equity funds received information about the results of the surveys conducted by the Norwegian Consumer Council, many fund customers had changed their portfolios four months later,” Haaland said.
Objective knowledge thus enabled people to choose differently, he said.
More people chose passive funds after they heard what the researchers had to say.
The researchers are now working to break down the figures from the survey in more detail. This might allow them to detect gender differences or other differences related to who does what with their investments.
Banks give bad advice
These findings relate to the fact that bank advisers very often recommend that clients invest their savings in actively managed funds. The simple explanation for this is, of course, that banks make more money selling expensive active funds than selling cheap passive funds.
For many Norwegians, saving into a fund is all about pension savings. And Norwegians have invested most of their fund assets in equity funds that invest money abroad, often in what are called global equity funds.
But this is where Norwegian actively managed funds do markedly worse than funds that only follow a benchmark index (global index funds), the Norwegian Consumer Council's survey shows.
Actively managed global equity funds delivered particularly disappointing results in 2018 and 2019. This poor performance contributed to making the return on these funds over the last 20 years - up to the first quarter of 2020 - a dismal -1.43 per cent (negative) each year as compared to their respective benchmarks.
The Norwegian Consumer Council warns that banks and financial advisers can inflict large losses on their customers by suggesting they buy active funds, rather than advising them to purchase passive funds.
Translated by Nancy Bazilchuk
The Norwegian Consumer Council: Er fondene som bankene anbefaler til kundens beste? (Are the funds that the banks recommend in the customer's best interest?) June 2020.
Read the Norwegian version of this article at forskning.no