Why Do Index Funds Have Market Power? Quantifying Frictions in the Index Fund Market

62 Pages Posted: 31 Oct 2023 Last revised: 21 May 2024

See all articles by Zach Brown

Zach Brown

University of Michigan

Mark Egan

Harvard University - Business School (HBS); National Bureau of Economic Research (NBER)

Jihye Jeon

Boston University

Chuqing Jin

University of Toulouse Capitole - Toulouse School of Economics

Alex A. Wu

Harvard University

Multiple version iconThere are 2 versions of this paper

Date Written: May 21, 2024

Abstract

The number of index funds increased drastically from 2000 to 2020, partially fueled by the emergence of exchange-traded funds (ETFs). Despite the growing availability of similar products, price dispersion persists, with many expensive funds still available, indicating significant market power among index funds. One explanation is that investor inertia limits the adoption of new products and interacts with other market frictions to restrict competition. To understand the sources and implications of market power, we develop a tractable quantitative dynamic model of demand for and supply of index funds that accounts for information frictions and heterogeneous preferences, in addition to inertia. These frictions on the demand side create market power for index fund managers, which fund managers can further exploit by price discriminating and charging higher expense ratios to retail investors. We find that inertia is high, with only 13% of households updating their portfolio at least once yearly. Although inertia is high, its impact on the investment behavior of households is limited because they struggle to optimize investment decisions due to information frictions. Thus, there is an interaction between the two frictions—inertia is more costly for investors when information frictions are low. We show that although the introduction of ETFs lowered expense ratios through both the cost advantage of ETFs and increased competition, demand-side frictions limited product adoption.

Keywords: Index Funds, Demand Estimation, Market Power

JEL Classification: G11, G23, L11

Suggested Citation

Brown, Zach and Egan, Mark and Jeon, Jihye and Jin, Chuqing and Wu, Alex, Why Do Index Funds Have Market Power? Quantifying Frictions in the Index Fund Market (May 21, 2024). Available at SSRN: https://ssrn.com/abstract=4591882 or http://dx.doi.org/10.2139/ssrn.4591882

Zach Brown

University of Michigan ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States

Mark Egan

Harvard University - Business School (HBS) ( email )

Soldiers Field Road
Baker Library 365
Boston, MA 02163
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jihye Jeon

Boston University ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

Chuqing Jin

University of Toulouse Capitole - Toulouse School of Economics ( email )

Toulouse
France

Alex Wu (Contact Author)

Harvard University ( email )

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