Why do investors pay for additional expenses? A limited learning simulation for the expense ratio dispersion of active mutual funds

The literature confirms the existence of expense dispersion in active funds that cannot be fully explained by known factors. Why would investors pay for unexplained additional expenses? We develop a limited learning agent modeled by a dual-reasoning model inside an active fund market to reveal the mechanism of expense dispersion in such markets. Whether an agent learns depends on the tradeoff between the loss of decision errors and the associated cognitive cost. We derive an agent's conditions to fall into habitual decision-making steady states. Our simulation reveals that two types of steady-state agents allocate money to high-fee funds: agents with normal-level wealth who diversify due to concerns about diseconomies of scale in returns and agents with low-level wealth who allocate almost all of their money to high-fee funds and remain in a low-wealth steady state. Furthermore, by providing additional wealth, our supplementary experiments reveal a one-way effect of biased investment habits on the low-wealth steady state. Low-wealth investors still have a 53 %–87 % probability of falling back after additional funding, which is much greater than the probability of naïve investors falling into the low-wealth steady state (10 %–12.7 %). This finding corroborates the explanation of the unsophisticated or price insensitivity of low-wealth agents and is consistent with existing evidence in the literature.