Index Mutual Funds and Exchange-traded Funds: Structural Distinctions

Guedj and Huang discussed the clienteles for ETFs and index mutual funds that coexist within the investment world, tracking the same set of assets. Their model examined the long-term effectiveness of the structures of open-ended mutual funds (OEFs) and ETFs. 

They suggested that individuals with high idiosyncratic liquidity needs are ill-suited to provide liquidity to others under the ETF regime. Therefore, they argue that OEFs are a sounder choice because of the embedded liquidity of the OEFs when contrasted with the high costs of transacting at volatile prices using ETFs. 

The liquidity insurance benefits in the OEFs are not without costs-they can cause moral hazard issues that include excessive trading that reduces the returns of OEFs. The liquidity needs of individual investors differ so the extent of moral hazard issues depends upon their specific investment profiles. In this vein they showed that OEFs provided cross-subsidization among investors by sharing the transaction costs. 

Their efforts here are truly an analysis of what role the ETF industry will play going forward as a robust competitor to OEFs. They denoted differences in the products especially with regard to liquidity issues. These differences led them to certain conclusions. They did not find ETFs to be more efficient than OEFs. They said it was a zero-sum game between those who cause the fund flows and those who bear the flow-induced trading costs. 

Finally, they predicted that ETFs are more suitable for investors who have correlated liquidity shocks or when underlying indexes are narrower or less liquid. The two products while actively competing for investors' hard-earned dollars still have enough distinctiveness or individual merits so as to coexist and serve somewhat different investment protocols.

Source: Guedj, I., & Huang, J. (2010, March). Are ETFs Replacing Index Mutual Funds? Located at http://ssrn.com/abstract=1108728.