Will ETFs Drive Mutual Funds Extinct?
86 Pages Posted: 6 Nov 2023 Last revised: 29 Nov 2023
Date Written: November 6, 2023
This paper challenges the conventional wisdom that exchange-traded funds (ETFs) are more liquid than open-end mutual funds. I build a model and establish that same-index ETFs and mutual funds provide liquidity at different horizons. Investors facing higher (lower) liquidity risk and thus shorter (longer) investment horizons prefer mutual funds (ETFs). Since they can be redeemed at NAV, mutual funds holding illiquid assets provide higher short-term liquidity, but the resulting payoff complementarities make them underperform ETFs in the long run. ETFs, however, are subject to mispricing and illiquidity in the short term due to arbitrageurs’ balance-sheet constraints. In equilibrium, both funds coexist when investors face heterogeneous liquidity needs. The model generates novel, testable predictions concerning the competition and future trajectory of index ETFs and mutual funds.
Keywords: ETFs, index mutual funds, liquidity provision, portfolio choice
JEL Classification: G11, G23
Suggested Citation: Suggested Citation