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Are Investors Rational? Choices among Index Funds


  • Edwin J. Elton,

  • Martin J. Gruber,

  • Jeffrey A. Busse

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    • Elton and Gruber are at the Stern School of Business, New York University. Busse is at the Goizueta Business School, Emory University. We thank Rick Green (the editor) and two anonymous referees for helpful comments and LiTing Cheng for research assistance.


S&P 500 index funds represent one of the simplest vehicles for examining rational behavior. They hold virtually the same securities, yet their returns differ by more than 2 percent per year. Although the relative returns of alternative S&P 500 funds are easily predictable, the relationship between cash flows and performance is weaker than rational behavior would lead us to expect. We show that selecting funds based on low expenses or high past returns outperforms the portfolio of index funds selected by investors. Our results exemplify the fact that, in a market where arbitrage is not possible, dominated products can prosper.