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

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, indicating significant market power among index funds. We show evidence that investor inertia along with other market frictions may be restricting competition. To understand the sources and implications of market power, we develop a tractable empirical dynamic model of demand for and supply of index funds that accounts for inertia, information frictions, and heterogeneous preferences. Using a novel identification strategy, we find that inertia is high, with only 1-3% of households updating their portfolio each month. Although inertia is high, its impact on the investment behavior of households is limited because investors struggle to optimize due to high information frictions. We show that although the introduction of ETFs lowered expense ratios through both the cost advantage of ETFs and increased competition, demand-side frictions substantially dampened the competitive effect.