The Index Fund Rationality Paradox and Categorical Thinking

Abstract

During the last twenty years, literature has emerged researching into why an individual investor invests in high-fee index Mutual Funds (MF) while there are funds tracking the same index charging remarkably lower commissions. Another strand of literature has explored why those Exchange-Traded Funds (ETF) which follow the same index more effectively have still not replaced identical index mutual funds. This paper reports further research exploring the possible reasons for the index fund rationality paradox. The experiment, conducted among first generation High Net Worth Individuals (HNWI) and economics and finance students from leading universities, demonstrates that none of the known theories explaining this paradox can be considered the main reason. The paper provides the rationale why the underlying explanation for this paradox might be people’s predisposition for categorical thinking or stereotyping. In addition, the article formulates the basic principles for minimizing the negative effect of categorical thinking concerning non-optimal index-investing behavior. In conclusion, some ideas for further research are proposed.