Sedate and Inept
Index tracking is supposed to be a sedate affair, a quiet contemplation of the tempestuous dynamics of market forces from an appropriate distance. A passive approach to investing, if you will. Instead it seems that people who use index trackers either don't understand that they're simple commodities or simply trade them like any other instrument available to private investors: frequently, ineptly and in a manner calculated to abrogate their inbuilt advantages. Nothing new there, then.
Dumb Money
As we saw in Intelligence Can Seriously Damage Your Wealth, many bright people seem unable to understand that index trackers are essentially commodities, where the main consideration ought to be the total expense ratios of the various funds. After all, one S&P500 tracker ought to be much like another, but all too often smart people end up paying higher fees than necessary, seemingly because they're confused by the opaqueness of the charging structures.
This is what Michael Boldin and Gjergji Cici call The Index Fund Rationality Paradox. On investigating this puzzle they come up with a couple of interesting findings. Firstly they suggest that this isn't the widespread problem it has previously appeared to be, because the anomaly seems to be explained: "As being largely driven by an identifiable group of unsophisticated investors that buy funds through brokers. This finding is noteworthy because it contrasts with industry claims that the structural features of funds that charge loads and/or 12b-1 fees are beneficial to investors." Essentially investors who use brokers tend to end up with expensive index trackers which, the industry claims, add value through extra services. However, the researchers suggest, these extra fees are often actually used to incentivize intermediaries to push naive investors into these funds.
Secondly, though, and on a more positive note they also find that the paradox is decreasing in general as most investors are learning to select their funds based on total expense ratio – a finding that indicates that they're behaving more rationally over time. This is, at least, vaguely encouraging, because it suggests some of the messaging about the advantages of passive investing are getting through. However, we should never underestimate our innate ability to screw up even the most foolproof of plans.
Cold and Tasty Turkey
Of course index tracking is supposedly about passivity – a fixed and formulaic approach to stock…
