Abstract

We model same-index ETF competition. Heterogeneity in investor horizons allows ETFs to build liquidity clienteles, leading to fee differentials. More liquid ETFs charge higher fees in equilibrium, attracting short-horizon investors who are more sensitive to liquidity than to fees. Higher turnover from short-horizon investors sustains the ETF’s high liquidity. Liquidity segmentation generates ETF rents and reduces welfare. Empirically, we confirm the presence of liquidity clienteles and argue that ETF fee differentials provide a novel measure for the value of liquidity. Our findings resolve the apparent paradox that ETFs charging relatively higher fees can not only survive, but flourish in equilibrium.

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