When Risk and Return are Not Enough : The Role of Loss Aversion in Private Investors' Choice of Mutual Fund Fee Structures

Using data from surveys as well as as real transactions we analyze which and why investors choose funds with performance fees even though these funds may be more expensive. According to agency theory, performance fees could incentivize managers to achieve better returns, but they could also result in excessive risk taking. While we find evidence that these considerations indeed matter for investors, a major and consistent determinant for selecting a performance fee fund is individual loss aversion: Both survey subjects and online broker clients are more likely to buy funds with a performance fee when they are loss averse, i.e. prefer the lower amount of total fees to be paid in case of fund losses. Our results show how Prospect Theory preferences can help explain the emergence of certain financial products beyond other "classical" explanations