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

The number of index funds increased drastically from 2000 to 2020, driven in part by the emergence of exchange-traded funds. Yet, despite the proliferation of near-identical products, fee dispersion remains large and persistent, implying substantial market power. Motivated by evidence of strong inertia and other demand-side frictions, we develop a dynamic model of demand and supply for index funds that incorporates inertia, information frictions, and heterogeneous preferences. Using a new identification strategy that leverages fund-level new-sales data, we estimate that only 3–5% of households update their index holdings each month. However, counterfactual simulations show that while eliminating inertia alone reduces average fees by only 20%, eliminating both information frictions and inertia cuts them by 80%. This highlights that high information frictions—and their interaction with inertia—are the primary barriers to reallocation. Finally, we show that while ETF entry reduced expense ratios through both lower costs and additional product-market competition, demand-side frictions substantially dampened this competitive effect.