If low-cost index funds are considered the best investment, why are there so many high-cost, managed funds?

Question

The general consensus is that the single best indicator of a fund's future performance is the its expense ratio (source). If you look for more than 5 minutes online you discover the Bogleheads approach to investing; the Motley Fool's discourse on mutual funds, etc. It looks like the less you pay for a fund (and therefore the less it's managed), the better it does in the long run.

So why is it that in peoples' 401(k)s there are so many high-cost actively managed funds? Furthermore, why are there so many high-cost actively managed funds in the first place? Shouldn't the market reflect the fact that actively-managed funds typically don't beat the index they benchmark to and and react by purging itself of these crappy funds?

Answer 1

Hope springs eternal in the human breast.

No actively managed fund has beaten the indices over a long period of time, but over shorter periods, actively managed funds have beaten the indices quite often, sometimes quite spectacularly, and sometimes even for many years in a row. Examples from the past include Fidelity Magellan and Legg Mason Value Trust. So people buy actively managed funds hoping to cash in on such good performance. The difficulty is, of course, that many people don't even think about investing in a fund until it is listed in some "Top Forty Funds of last year" compilation, and for many funds, they have already peaked, and new buyers are often disappointed. Some people who invested earlier plan on getting out of the fund before the fund falls flat on its face, and fewer even succeed in doing so.

As to why 401k plans often have high-cost actively managed funds, there are several reasons. A most important one is that there are numerous companies that act as administrators of 401k programs and these companies put together package deals of 401k programs (funds, administrative costs etc), and small employers perforce have to choose from one of these packages. Second, there are various rules that have come into existence since the first days of 401k (and 403b) programs such as the investment choices must include funds of different types, and actively managed funds (large cap, small cap etc) are one of the choices that must be offered. Gone are the days when the only choice was a variable annuity offered by the insurance company administering the 401k program. Finally, program participants also have hopes (cf. opening sentence) and used to demand that the 401k program offer a few actively managed funds, not just index funds.

Answer 2

It's very simple.

The low cost index funds are generally the best investments for investors, but - because of the low fees and the fact that the offerings of different companies are nearly identical - they are the worst for the investment houses. Therefore, the investment houses spend a lot of money convincing investors to choose other funds.

If you remember that investment houses are all in the business of making money for themselves, not for the investor, then the whole financial system will make much more sense.

Answer 3

Decades of research has shown that smoking has no beneficial effects and has many detrimental ones, some quite serious. So why does anyone still smoke?

Decades of research has shown that wearing a seatbelt greatly reduces your likelihood of dying in a car accident. So why do some people still not wear them?

Many individuals have learned over time that scratching a persistent itch (like poison oak) will provide only temporary relief, ultimately making the itch worse and perhaps even causing bleeding or further damage. So why do people still scratch these itches?

The answer to these is the same as the answer to your question: people are fallible. People are often foolish, weak-willed, or simply unaware of relevant information that would help them make the best choice, even if they knew what it was. People do not always do what is best for them.