Skilled portfolio managers can persistently add value to a fund in a way that is not the result of luck. Investors are able to recognize this skill and invest more in the funds managed by skilled managers. Thus, the fund size increases and the portfolio managers are paid even more. The added value that is created is not always shared with the investors; in fact, the average investor’s net alpha is strongly negative. The question the author asks is, Why do investors who can identify skilled managers in active funds continue to be satisfied with below-market returns? He concludes that these investors are not rational and discusses four possible reasons.

First, investors with high financial literacy presume themselves competent to select high-performing actively managed mutual funds, which makes them overconfident. Investors with high financial literacy believe that they are able to select outperforming actively managed mutual funds and would rather do that than invest in “boring” index funds that offer only average performance. Unfortunately, the evidence indicates that they are not as savvy as they believe.

Second, mutual fund managers opportunistically re-price expense ratios when investor sensitivity to expense ratios and performance changes. Increased investor sensitivity to high performance coincides with declines in sensitivity of investor flows to high expenses, which is called the “distraction effect.” When funds do well, investors appear to forget high expenses, as if distracted by perceived management ability and expectations of high returns.

Third, mutual fund managers use market sentiment risk linked to performance to obscure actual performance, an approach that is driven by sentiment contrarian behavior. The managers opportunistically time when to load up investors with sentiment risk, and investors wrongly perceive the resulting riskier returns as high performance. This strategy is successful because the market does not recognize the existence of sentiment risk and remunerates sentiment risk taking as a sort of performance. Some fund managers cleverly exploit investors’ inability to identify sentiment risk.

Fourth, the ignorance or irrationality of retail mutual fund investors drives them to depend on brokers for advice. But broker incentives motivate them to keep investors in underperforming actively managed funds, which creates a major agency conflict. Actively managed mutual funds that are sold by brokers persistently underperform because of the weaker incentives to generate alpha. But investors in broker-sold mutual funds value face-to-face contact and “investing peace of mind.” They are willing to accept lower expected returns to get higher-quality services. High fund payments to brokers provide strong sales incentives, which enable funds to compete for inflows more effectively. So, investors rely on brokers’ advice about investments even though the advice is being driven by sales incentives rather than fund performance.

To answer the question of why investors continue to buy underperforming actively managed mutual funds, the author reports the important findings provided by other researchers.

For overconfidence, researchers in the relevant study analyzed whether higher levels of financial literacy coincide with improved fund selections and whether literacy affects the tendency to invest in actively managed funds rather than lower-cost index funds. Data from an online sample of 3,000 German mutual fund investors were used in the analysis.

For the distraction effect, researchers in the relevant study investigated the investor response to expenses measured in conjunction with investor sensitivity to past performance. The result indicated that investors are less sensitive to the expenses of the fund when the past performance is good, and vice versa. Funds strategically time repricing decisions to exploit time variations in investor sensitivity to prices and performance.

For the sentiment contrarian behavior, researchers in the relevant study compared the performance of high sentiment contrarian behavior (SCB) funds with that of low SCB funds. Although high SCB funds provide a better return, it is the result of taking higher sentiment risk, and thus it is “fake” performance. Because the investors are not aware of sentiment risk, they wrongly perceive riskier returns as high performance and load up with those funds.

For the agency conflict, researchers in the relevant study compared fund performance between direct-sold and broker-sold mutual funds. The result indicated that the former outperformed and the latter underperformed the index fund. They also analyzed investor preferences and broker’s incentives and concluded that retail investors are most likely unaware of the underperformance of broker-sold actively managed funds and that their investment decisions are guided by brokers, who are driven by sales incentives.

As stated by the title, “Mutual Funds Win and Investors Lose,” skilled managers are able to create alpha in portfolio management. But the added value created is not shared with the investors. To help investors, the industry should develop a risk measure that covers sentiment risk and advocate for the disclosure of the brokers’ commission and after-fee alpha. Although uninformed investors may not be aware of their irrational investment behavior, the industry should do something to stop managers from exploiting the general public.