What’s in a fund name? More – and less – than you might imagine.
According to a new paper by academics at Kansas State, Saint Louis University and Seton Hall, along with a researcher at the Ipsos Behavioral Science Center, when a participant searches through her plan’s menu of investment options, she may be more likely to choose the funds appearing towards the beginning of the list. And then, since 401(k) fund choices with early alphabet names appear at the beginning of the list, they will be chosen more often than later alphabet named funds.
The authors explain that this “alphabeticity bias” is the phenomenon in which early-alphabet options are chosen more frequently than others. While the researchers acknowledge that many investors can access their plans online and may be able to re-order their list of fund choices, individuals generally rely on the default (status quo) list given to them.
Apparently alphabeticity is a thing – the paper cites research that has found that politicians with early-alphabet names are more likely to be elected than their competitors, scholars with last names that begin with a letter early in the alphabet are invited to review papers more often than those with last names that start with letters later in the alphabet, and – ostensibly because they are solicited more often – alumni with early-alphabet names donate more than those with later alphabet names. Moreover, they note that stocks beginning with early-alphabet letters have been found to have higher turnover, liquidity and valuation than later-alphabet stocks.
And, in fact, the researchers did find that alphabeticity bias indeed affects investment allocation decisions in DC plans. Citing an example of a 401(k) plan that offers 13 funds (listed alphabetically, of course), they determined that if the Royce Pennsylvania Mutual fund changed its name to American Royce Pennsylvania Mutual (a 10-position increase, moving it to the top position when listed in alphabetical order), investment in the fund would increase by roughly 20%, all else being equal. And that, they say, represents an additional allocation of $653,000 to the Royce fund in the average plan with $32.5 million in assets.
Of course, it’s not so much the place in the alphabet as the place on the fund menu. The paper notes that, for example, if a 401(k) plan offers only Vanguard funds (each starting with the word Vanguard), then the Vanguard 500 Index fund is likely to be listed first. But that if a 401(k) plan offers Vanguard funds as well as funds from other families, then the Vanguard 500 Index fund is likely to appear near the bottom of the list. And sure enough, they found that the same fund appearing in multiple plans in the sample receives a significantly higher allocation when it is listed closer to the top of the plan menu.
They also note that, while more fund choices and a more diverse offering may exacerbate the alphabeticity bias (and it did), they found evidence of the bias even in plans with fewer than 10 fund choices.
Think it applied differently among more highly educated workers? Not a chance. They found that all participants, on average, display the bias equally – even professionals employed in the financial sector.
In exploring other possible explanations, the researchers note that Fidelity orders funds within plan menus slightly differently – by asset class first, then alphabetically. “After modifying the order of funds in Fidelity’s plan menus in our analysis to be consistent with their actual ordering, the results support the hypothesis that participants default to the status quo ordering and then satisfice by choosing options closer to the top of the menu.” Nor, apparently, were results driven by recently added funds with low balances predominantly inhabiting the bottom of plan menus. “In every case, regardless of the sample or subsample used, the results are robust, consistent with the original findings, and support our main hypothesis,” they wrote.
As a way to counter this bias, the researchers note that “rather than having funds arbitrarily listed in alphabetical order, plan sponsors could request that TPAs strategically order funds so the effect of alphabeticity bias results in a favorable outcome for participants,” say by expense ratio rather than alphabetically.
“Simply put, for those who are prone to alphabeticity bias, the same factors that biased their allocation decisions could lead them to select fund options that improve their overall investment outcomes,” they conclude.
And they don’t stop there, suggesting that “Nudging investors towards selecting lower expense ratio funds could also motivate mutual fund companies to include cheaper funds in 401(k) plan menus knowing their more expensive funds will receive less investment because of being listed later in the plan menu.”