Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: A Case Study of S&P 500 Index Funds

Abstract

provided thoughtful suggestions regarding earlier drafts. We have also benefited from discussions with ABSTRACT Two salient features of the competitive structure of the U.S. mutual fund industry are the large number of funds and the sizeable dispersion in the fees funds charge investors, even within narrow asset classes. Portfolio financial performance differences alone do not seem able to fully explain these features. We investigate whether non-portfolio fund differentiation and information/search frictions also play a role in creating these observed industry characteristics. We focus on their impact in a case study of the retail S&P 500 index funds sector. We find that fund proliferation and price dispersion also exist in this sector, despite the funds'' financial homogeneity. Furthermore, there was a marked shift in sector assets to more expensive (often newly entered) funds throughout our sample period. Our analysis indicates that these observations are consistent with the presence of both nonportfolio differentiation and information/search frictions. Structural estimation of a novel searchover-differentiated-products model reveals that reasonable magnitudes of investor search costs can explain the considerable price dispersion in the sector, and consumers seem to value funds'' observable attributes -such as fund age and the number of other funds in the same fund family-in largely plausible ways. The results also suggest that the substantial increase in mutual fund market participation observed during our sample, and the corresponding purchase decisions of novice investors, drove the shift in assets toward more expensive funds. We also find evidence consistent with the presence of switching costs, as distinct from search costs. Using structural estimates of demand parameters and search costs, we investigate the possibility that there are too many sector funds from a social welfare standpoint. The results of this exercise indicate that restricting entry would yield nontrivial gains from reduced search costs and productivity gains from scale economies, but these may be counterbalanced by losses from increased market power and reduced product variety.

Consumer Financial Protection

“…These search costs give retailers a degree of market power, allowing them to charge prices above marginal cost. One example in the financial arena is the wide range of fees charged for nearly identical stock market index funds based on the Standard and Poor’s 500 index (Hortaçsu and Syverson, 2004). Policy responses include standardized or centralized information provision to reduce search costs, or direct price regulation.…”

How are preferences revealed?

“…A great deal of real behavior is also influenced by marketing. For example, S&P 500 index funds charge fees that vary by an order of magnitude (Hortaçsu and Syverson, 2004). Moreover, this range of fees cannot be explained by variation in bundled non-portfolio services, such as customer service quality (Choi, Laibson, and Madrian, 2006b).…”

Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds

“…Hence, it is puzzling that competition has not eliminated high-fee funds. The puzzle is especially acute in the index fund market, where funds tracking a given index offer virtually identical portfolio returns before fees, but price dispersion is no smaller than in the actively managed fund market (Hortaçsu and Syverson, 2004). In 2007, retail S&P 500 index fund investors paid $206 million more in expenses (not including sales loads) than they would have if their entire S&P 500 index fund balance were in the retail no-load S&P 500 index fund with the lowest expense ratio.…”

“…Some researchers have argued that high index fund fees reduce investor welfare, since they are sustained by investors’ search costs (Sirri and Tufano, 1998; Hortaçsu and Syverson, 2004) or mistakes abetted by mutual fund marketing (Elton, Gruber, and Busse, 2004; Barber, Odean, and Zheng, 2005; Cronqvist, 2006). The mutual fund industry has countered that “S&P 500 index funds themselves are not commodities.…”