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Therefore, apparently, index funds investor donot want to overpay for “not much promising” active money management service.Researchers pose the question how to explain that these apparently rationalinvestors make such a non-optimal choice among index funds (Boldin and Cici,2010; Müller, Weber, 2010).Choi et al. (2010), summing up the results of previous studies in theirexperiment demonstrate the insufficiency of previously well-founded hypotheses(described in chapter 3). However, the authors do not answer the question aboutthe reasons. Boldin and Cici (2010) agree that there is no reasonable motivation foran investor to choose high fee index funds. They call this behavior Index FundRationality Paradox.
Debating with Choi et al. (2010), Boldin and Cici (2010)argue that this paradox exists due to the naïve investors that are easy influenced byfinancial advisors.Taking into account the above mention academic discussion, for myexperiment I invited participants who should not be called naïve investors. I testthe hypothesis that people with high level of financial education (or investmentexperience) fully understand the difference among three major groups open-endedmutual funds: active funds, index funds and fund-of-funds, those portfolio consistalmost out of shares of one pre-selected ETF.The design of the experiment aims to exclude as far as possible all knownrational factors that have the potential to influence the decision-making process.The starting point for developing the methodology is the design of the Choi et al.(2010) experiment, conducted in the Harvard Business School.
In addition tocreation of even more favorable conditions for participants and to participants levelof financial education or experience, I develop the speed test to check theparticipant ability to identify passive funds from the general list by asking them to11compare the fund manager skills and efforts (workload) needed to execute theirtasks regarding the portfolio management.The research results allow to believe that an important obstacle to fullunderstanding of the difference between passive and active funds is the people’snatural predisposition to automatic categorization of surrounding world.Categorization is an unconscious information simplification process that exists fortwo reasons (Rosch and Mervis, 1975): first, the limitations of human cognitiveresources and the permanent need for their optimization; secondly, people's needfor a constantly well-structured picture of surrounding world.
Categorization is thefirst reaction of our mind to any stimulus (Bruner, 1957).Therefore, in the conclusion I propose several changes in economic policy inline with "libertarian paternalism" 2003) aiming at increasing the chance of betterunderstanding the key points of the service provided by mutual funds. Forexample, following the US regulator idea, it is possible to require all active fundsto specify an index (benchmark) those return a fund plans to outperform.Otherwise, most people barely realize that the key goal of each active fund is toprovide its investors with the return higher than the index's one (exactly to say thatof index funds), rather than that of an bank deposit, as the overwhelming majorityof Russian investors thinks today.ContributionThe dissertation thesis expands research into Russian open-ended mutualfund industry.
In particular, this is the first Russian dissertation related to newproducts for the Russian market - exchange traded funds (ETF). This is also thefirst study of the Russian market, where a new mutual funds assessingmethodology is applied - the "active share" (Cremers and Petajisto, 2009). A newapproach was also applied when searching for the answer whether the fundsoutperform the Russian main index: e.g., funds that invest mostly in foreign assetsare excluded from the date-set, as in Fama and French (2010), for example, and12guided by the principles of general logic. The paper identifies two types of closetindexing used by Russian mutual funds, documents and researches into theindividual investors behavior who buy fund units whose portfolio consists ofshares of one pre-selected ETF.
The formation of proposals for market regulationin the paradigm of "libertarian paternalism" (nudging) is also a scientific andpractical contribution of the thesis.The results show that a larger fund active share is associated with higher fee(which is consistent with the results for other countries), but does not lead to agreater net return (it does not in line with other countries research). The resultsshowing the lack of a complete understanding by most investors of the maindifference between active and passive funds due to the natural people’spredisposition to automatic categorization of the surrounding world are also acontribution to the world academic theory of investment funds. Finally, the paperpresents a comprehensive survey of the academic literature on ETF, which alsoincludes a review of the papers which were not included in reviews previouslypublished.
For the first time, the stages of ETF market development aresystematized and their classification is proposed.Main FindingsFirst. There are two types of closet indexing strategies on the Russian market:1. Active fund indexing: when an active fund mostly tracks its benchmarkinstead to try outperforming it (“closet indexing”);2. Fund-of-funds indexing: when a fund invest all money into shares of onepre-selected ETF (“implicit indexing”).Second. The study of the active fund indexing shows a negative correlationcoefficient on significant level between a fund activity level (Active Share) and itsrisk-adjusted net return (alpha): the active fund manager who tracks its benchmarkmore, on average, provide his investors with better net risk-adjusted financial resultthan the fund manager actively seeking this index outperform.13Third.
Calculation of the fund-of-funds indexing ("implicit indexing") impactdemonstrates that investors expenses on the mutual funds fee over a 10-yearperiod could reach up to 36% of the invested capital, whereas expenses oninvesting via discount broker account for the same period do not exceed 2-3%.Fourth. On average, active funds which invest mostly in broad Russian market donot outperform the index funds and, obviously, the broad market index (MICEX)during the period starting at the end of 2010.Fifth. The behavioral phenomenon of non-optimal choice of the way by investingin ETF – via mutual funds, rather than directly – I attribute to a manifestation ofthe index funds irrationality paradox. Experimental research shows that, even inspite of high level of financial education (or investment experience), additionalsupporting information, people view all funds as representatives of one category,without dividing them according to the "active / passive" criterion.
Perhaps, theyhave it difficult to overcome the natural people’s predisposition to automaticcategorization of the surrounding world.Sixth. I propose several changes in economic policy in line with "libertarianpaternalism" 2003) aiming at increasing the chance of better understanding the keypoints of the service provided by mutual funds. For example, following the USregulator action, it is possible to require all active funds to specify an index(benchmark), those return a fund plans to outperform.The main results of the dissertation research were presented on theconferences listed below1. XIII interuniversity conference “Stock market: current issues andopportunities for individual investor”, Moscow Stock Exchange, 2016.2.
«Seventh International Research Meeting in Business and Management»Nice, 2016;3. «Third Russian Economic Forum», New economic association, Moscow,2016144. «Experimental Finance conference», Nice, 2017;5. PhDworkshop"FinancialMarketsandCorporateStrategies:Comparative Studies", XIX international conference, Moscow, 2018.Publications1. Tarassov Е. B. ETF: history, mechanism, academic literature review andresearch perspectives // Journal of Corporate Finance Research.
2016. Vol.38, no. 2, pp. 89-108.2. Tarassov Е. B. The Index Fund Rationality Paradox and CategoricalThinking // HSE Economic Journal, 2017. vol. 21, no. 3, pp. 412 - 433.3. Inozemtsev E.V., Tarassov E. B. Actively managed Russian mutual funds:Good or bad for investors? // Voprosy Ekonomiki, 2018, no. 3, pp. 64—79.(in Russian)4. Tarassov Е. B. The Russian ETF puzzle and its possible reasons//Algorithmic Finance, 2017. vol.
6, no. 3-4, pp. 93-102.5. Tarassov Е. B. Exchange Traded Funds (ETF): Anomaly on the RussianMarket // Stock market: current issues and opportunities for individualinvestor. XIII interuniversity conference, Moscow 2017, pp. 317 – 331.Structure. The dissertation research is written on 167 pages, includes 20 tables, 20pictures and consists out of introduction, three chapters, list of the literature andsix annexes.15.
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