An individual level analysis of the mutual fund investment decision

This study investigates the manner in which consumers make investment decisions for mutual funds. Investors report that they consider many nonperformance related variables. When investors are grouped by similarity of investment decision process, a single small group appears to be highly knowledgeable about its investments. However, most investors appear to be naive, having little knowledge of the investment strategies or financial details of their investments. Implications for mutual fund companies are discussed. The growth of mutual funds is arguably the most important phenomenon of present day financial markets. Although comprising less than $50 billion in assets in 1977 ($111 billion in 1993 dollars) in-under 500 funds, by 1989, over 30 million individuals had invested $982 billion in 2917 funds ($1,123 billion in 1993 dollars (Mutual Fund Fact Book, 1990). By early 1993, assets under management had leapt to $1.6 trillion in 3848 funds and accounted for fully 11.4 percent of U.S. financial assets (Mutual Fund Fact Book, 1993).^ Total mutual fund assets dwarfed savings and loan deposits and were, respectively, 98 percent of life insurance company assets and 66 percent of commercial bank deposits. Some industry observers predict that mutual fund assets will rise to $4 trillion by the year 2000 (Business Week, 1993). This enormous concentration of assets into relatively few hands allows mutual fund managers to exercise immense power in financial markets. Unfortunately, the growth in mutual fund assets has not been paralleled by a corresponding focus on the processes by which mutual fund investors make investment decisions. Indeed, students of mutual funds have been forced to rely on modern finance theory for insight. This theory rests on the assumption that purchase decisions for individual financial assets should be made on the basis of investor beliefs regarding the future The authors acknowledge support from the Center for the Marketing of Financial Services, Graduate School of Business, Columbia University and from several anonymous mutual fund companies. Author Capon acknowledges support from the Redward Foundation. The authors wish to acknowledge the efforts of two anonymous reviewers whose painstaking efforts were extremely helpful in preparing this article for publication. 60 NOEL CAPON, GAVAN J. FITZSIMONS, AND RUSS ALAN PRINCE return and risk of those assets and the covariance of those returns with other financial assets in the investor's portfolio (Markowitz, 1959; Elton and Gruber, 1989). Descriptive inferences of investor behavior are frequently drawn from these theoretical underpinnings, although they are primarily normative in character. By focussing upon just these two economic factors (return and risk), considerable understanding of mutual fund investors' purchase decisions is foregone. In this article, we employ a consumer behavior perspective to gain insight into the decision processes employed by mutual fund investors. We operate under the assumption that consumers, at least implicitly, employ some form of multi-attribute model when making choices among mutual fund alternatives. We show that, as well as considering both anticipated return and risk in their purchase decisions, investors positively value other attributes. Thus, we argue, models of investor behavior that focus solely upon return and risk are, at best, naive vehicles for understanding the mutual fund investment process. We also find that mutual fund investors can be meaningfully grouped on the basis of similarities in both the use of information sources and selection criteria. The resulting groups differ substantially from each other in terms of information sources and selection criteria used in the investment decision. Cross-tabulating the information source and selection criteria groups produces a single set of composite groups; these groups differ substantially from each other in terms of both demographic characteristics and mutual fund investment behavior. Group membership ranges between well-informed, knowledgeable investors and others that are best described as naive. 1. Literature review 1.1. Investment in mutual funds Most research on mutual funds has employed two explanatory variables, namely, risk and return. This approach implicitly places no value on other potentially important attributes of the mutual fund investment decision. In keeping with this strictly economic frame, several scholars have investigated whether or not mutual funds outperform the market. Much early research (e.g., Sharpe, 1966; Jensen, 1968) showed that, on a risk-adjusted basis, mutual funds underperform the market. More recent studies, for example, Ippolito (1989) and Grinblatt and Titman (1989, 1992), find some evidence of superior mutual fund returns. However, in a recent article. Brown, Goetzmann, Ibbotson, and Ross (1992, p. 553) conclude that "there is still no strong evidence that manager performance over and above market indices can justify the fees managers charge and the commission costs they incur." A second line of enquiry that also considers only return and risk is whether or not historic mutual fund performance predicts future performance. Several authors have concluded that past risk-adjusted mutual fund performance helps predict future riskadjusted performance (Elton and Gruber, 1989; Goetzmann and Ibbotson, 1991; Grinblatt and Titman, 1989, 1992; Hendricks, Patel, and Zeckhauser, 1993; Ippolito, 1989; Lehmann and Modest, 1987). Some evidence is fairly weak; other evidence is stronger. Although Brown, Goetzmann, Ibbotson, and Ross (1992) have argued that these studies AN INDIVIDUAL LEVEL ANALYSIS OF THE MUTUAL FUND INVESTMENT DECISION 61 suffer from potentially severe survivorship biases that may induce a repeat winner phenomenon, Goetzmann and Brown (1993) find performance persistence in a data set relatively free of survivorship bias. Relatedly, there is some empirical evidence that investors do in fact make mutual fund purchase decisions on the basis of past performance. Patel, Zeckhauser, and Hendricks (1992) and Kane, Snatini, and Aber (1991) report that previous fund performance, adjusted for risk, appears to be associated with net inflows to mutual funds. However, Sirri and Tufano (1992, p. 33) find that raw returns, which are not adjusted for risk, appear to drive fund growth. They suggest that "naive retail trend chasers" are even more responsive to the "noisier" measure of unadjusted performance. Notwithstanding the dominant focus on return and risk in the studes noted above, there is evidence that these variables alone are insufficient explanations of mutual fund investment decisions. For example, closed-end mutual funds frequently sell at substantial discounts or premia to the underlying net asset value of their component securities (Lee, Shliefer, and Thaler, 1991). In addition, Sirri and Tufano (1992) find that fund inflow to well performing open-end funds is much greater than fund outflow from consistently poorly performing funds. Using proxy variables for services, Sirri and Tufano (1992) also demonstrate that higher levels of service are positively related to net fund inflow. In part, on the basis of these results, Goetzmann, Greenwald, and Huberman (1992, p. 21) conjecture that "[there is] a broad base of naive investors who cannot tell or do not care that their portfolios consistently underperform" (emphasis added). If, in fact, consumers do not care that their portfolios underperform the market, we must assume that they place greater (or at least positive) value on other attributes. The implications are less clear if consumers simply cannot tell. Evidence that return and risk alone are inadequate as the only explanatory variables for mutual fund investment decisions is provided by a 1990 Consumer Reports survey of mutual fund investors. Although past performance and level of risk (safety) were rated the two most important factors in aggregate, several additional factors were also relevant: amount of sales charge, management fees, fund manager reputation, fund family (e.g.. Fidelity, Vanguard), clarity of the fund's accounting statement, recommendation from a financial magazine or newsletter, availability of telephone switching, the fact that funds are already owned in that family, and a friend's recommendation. Because of the distributional nature of these responses, it is quite likely that for some investors, past performance and level of risk (safety) were not the most important characteristics. That is, while in aggregate the highest means were for return and risk, variance about the mean could reasonably have individual consumers placing greater value on other characteristics. To summarize, an exclusive focus upon return and risk as factors driving mutual fund investment decisions appears to tell only part of a complex story. The lack of clarity regarding those mutual fund characteristics actually used by investors in making investment decisions is of considerable importance to academic researchers because of implications for the dominant paradigm of investor behavior. Furthermore, the practical ramifications are enormous. As the mutual fund industry concentrates and leading firms spend ever more heavily on developing and maintaining funds, and distributing and promoting these funds to investors so as to establish and secure their market positions, assumptions about investor behavior are ever more crucial. For example, in 1989, two 62 NOEL CAPON, GAVAN J. FITZSIMONS, AND RUSS ALAN PRINCE leading fund families. Fidelity and Dreyfus, spent, respectively, $60 million and $40 million on advertising (McManus, 1990). These expenditures represent approximately 20 percent of fund revenues; by comparison, in 1992, such leading advertisers as Procter and Gamble and Lever Brothers spent, respectively, 9.5 percent and 10.6 percent of revenues in consumer markets. Clearly, imprecise assumptions about investor behavior