Essays on Index Investing
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Financial fragility
Index mutual funds
Liquidity provision
Portfolio choice
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Abstract
The shift from active to passive investing has been one of the most important trends in finance over the past decade. Index investing, through open-end mutual funds and exchange-traded funds (ETFs), has emerged as the preferred strategy for long-term portfolio management across retail investors and a growing number of institutional investors. Mutual funds and ETFs control nearly equal portions of the over $$9tn$ in assets under management (AUM) within U.S-registered public index funds. Despite the perceived advantages of ETFs—including superior tax efficiency, intraday trading, and lower minimum investments—index mutual funds continue to maintain a substantial presence, prompting questions about their role in the world of passive investing. In this dissertation, I study the payoff differences between ETFs and index open-end mutual funds over the short and long term. I build a model and establish that same-index ETFs and mutual funds provide liquidity at different horizons. I challenge the conventional wisdom that ETFs are inherently more liquid than open-end mutual funds solely because they are traded intra-day on exchange. Investors facing higher (lower) liquidity needs prefer mutual funds (ETFs). Since they can be redeemed at net asset value (NAV), mutual funds holding illiquid assets provide higher payoffs when investors must liquidate fund shares at short notice. Yet, the resulting payoff complementarities make them underperform ETFs in the long run. ETFs, however, are subject to mispricing and illiquidity in the short term, particularly in times of market stress, due to arbitrageurs’ balance-sheet constraints. In equilibrium, both funds coexist when investors face heterogeneous liquidity needs. My model generates novel, testable predictions concerning the competition and future trajectory of index ETFs and mutual funds. ETFs are particularly suited for less liquid asset classes with a relatively patient investor base. Regulators should encourage retirement plan sponsors to add ETFs to the investment menu, given their potential advantages. Additionally, swing pricing not only reduces externalities among mutual funds investors but can also help mutual funds maintain a larger size vis-a-vis ETFs. Multi-share class fund structures benefit shareholders in the mutual fund share classes at the expense of investors in the ETF share class.
Advisor
Zeng, Yao