Why Do Investors Buy Expensive Index Funds? Quantifying Frictions in the Index Fund Market

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Index funds are one of the most common ways investors access equity markets and are perceived to be a transparent and low-cost alternative to active investment management. Despite these purported virtues of passive asset management, there still exists substantial price dispersion in the index fund market. Why do investors buy expensive index funds? We develop a novel quantitative dynamic model of demand for and supply of index funds. In the model investors are subject to inertia, information frictions, and have heterogeneous preferences. Our results suggest that the average expense ratios paid by retail investors are roughly 54% higher as a result of information frictions and are 20% higher as a result of inertia. Interestingly there is an interaction between these frictions. Inertia becomes much more costly for investors when information frictions are reduced. These frictions on the demand-side create market power for index fund providers, which providers exploit by price discriminating across consumers. We find that index fund providers' ability to price discriminate across retail and institutional investors increases the expense ratios that retail investors pay by 25%.