Why Do Index Funds Have Market Power? Quantifying Frictions in the Index Fund Market
Index funds are one of the most common ways investors access financial markets and are perceived to be a transparent and low-cost alternative to active investment management. Despite these purported virtues of index fund investing and the introduction of new products and competitors, many funds remain expensive and fund managers appear to exercise substantial market power. Why do index funds have market power? We develop a novel quantitative dynamic model of demand for and supply of index funds. In the model, investors are subject to inertia, search frictions, and have heterogeneous preferences. 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. Our results suggest that the average expense ratios paid by retail investors are roughly 45% higher as a result of search frictions and are 40% higher as a result of inertia compared to the friction-less baseline. In our counterfactuals, we find an interaction between search frictions and inertia—inertia imposes higher (lower) costs on investors when search frictions are low (high).
We thank Malcolm Baker, Alex MacKay, Ying Fan, Gaston Illanes, and Hanbin Yang and the seminar participants at the Boston Conference on Markets and Competition, Boston University, Carnegie Mellon University, London School of Economics, the Montreal Summer Conference on Industrial Organization, Northwestern, Stanford Institute for Theoretical Economics, and the University of Wisconsin IO/Finance Reading Group. Egan and Wu gratefully acknowledge financial support from the Division of Research of the Harvard Business School. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.