Are Mutual Fund Investors Getting Smarter?

Last Updated Mar 19, 2010 5:17 PM EDT

There are lots of reasons to be cynical about the ability of the average citizen to successfully invest for their long-term goals. They chase performance; they fall in love with supposed superstar managers; and they're terrible market timers. As a consequence, the average investor has earned returns that have lagged the overall stock market, and the typical retirement plan participant has fared poorly in saving for retirement.

That track record is what has led investment advisor and author Bill Bernstein to write that expecting the average person to successfully manage their own investment portfolio is akin to asking them to be their own airline pilot or surgeon.

It's hard to argue with that. There's no doubt that most investors would benefit nearly as much from unbiased investment advice as they do from competent medical care.

But as we await the arrival of some sort of universal investment care, there are reasons to be hopeful that the average investor is beginning to make better choices.

The first sign of hope is the growth of indexing. At the turn of the century, the market share of equity index funds was less than ten percent. Ten years later it has more than doubled to 21 percent. Much of that growth is attributable to the popularity of exchange-traded funds (ETFs). Yes, it's doubtless that a certain portion of ETF investors use them for market timing rather than long-term investing. But it's also doubtless that a significant portion of their growth is attributable to investors who have embraced the indexing philosophy.

The second hopeful sign is that investors appear to be much more cost sensitive in choosing their investments. The three firms that have taken in the most investor cash over the past five years -- Vanguard, American Funds, and BlackRock -- are all, to one degree or another, known for their low costs.

But that doesn't begin to capture the magnitude of the recent trend. Over the past ten years, 50 percent of all new money invested in equity funds went into funds with expense ratios that were half the industry average. And over the past three years, that category of funds has taken in an amazing 105 percent of equity fund cash flow.

Of course, these are short-term trends, and it's always possible that they'll reverse as investors become captivated by higher cost active strategies (like long/short funds, for instance). But the magnitude of these trends cannot be dismissed. They indicate that indexing is taking hold, and that costs are becoming the predominant factor in the choices investors are making. And that, to borrow from someone who's probably revisited their own investment decision-making process over the past few years, is a good thing.

  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.