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).