A Comparison of Index Funds and ETFs

Abstract

The academic literature on mutual funds has devoted a large body of research trying to understand if active equity mutual funds can actually generate abnormal returns. The conclusion is not favorable to the idea of ability in the industry and hence most researchers have advised investors to invest in a passive investment, an index. The first index fund was introduce by Vanguard in 1976. The market share of index funds crossed 9% in 1999, and now constitutes 17% of equity fund assets -- more than $1 trillion of the $6.2 trillion equity fund total. But, as John Bogle, the founder of Vanguard, puts it .... a funny thing happened on the way to the triumph of indexing -- the model changed. The dominance of the classic index mutual fund came to a virtual halt. That 9% asset share of 1999 has grown to only 10% today. The extra 7% in index fund market share have been accounted for by a mutant of that original investment form, the Exchange-Traded Fund (ETF). There are two main differences between Open-End Index Mutual Funds (OEF) and ETFs: First, ETFs allows for continuous trading throughout the day while OEFs can only be traded once a day and may even face frequent trading restrictions that limit the number of transactions an investor can conduct within a given period of time. Second, investors bear the full transaction costs incurred (both the explicit trading cost and the implicit price impact) when they transact in ETFs while they share that cost with the rest of the OEF investors. While the media has focused on the cost for OEF investors to subsidize liquidity traders in the fund, Chordia (1996) points out that this cross-subsidization can be viewed as a form of insurance against liquidity shocks (along the line of Diamond and Dybvig (1983)) and can be ex-ante beneficial to investors. Our main research question is to understand the phenomenal growth of ETFs and its implication for the structure of the mutual fund industry. A priory, there appears to be a lack of obvious clientele for ETFs: On the one hand, for passive index investors with reasonably long horizon, it is not clear why they would find it attractive to be able to trade continuously throughout the day. On the other hand, for traders with shorter horizons, they would actually be better off enjoying the liquidity subsidization provided by the OEF. Paradoxically, only for a very small subset of investors -- traders with extremely short horizons --does ETF appear to serve a viable function. However, if short-term traders are the main clientele, the growth in the ETF sector can only be fueled by participation of new investors and can only represent a fraction of the overall index demand in the long run. On the other hand, if other investors find ETFs attractive despite (or because of) the presence of short term investors, ETFs may eventually dominate OEFs as a mean to track indexes.