ETF Competition and Market Quality

Abstract

Our paper investigates competition between ETFs that hold nearly identical baskets of securities. We provide strong evidence that incumbent-fund market quality is negatively affected when a new fund is added to an asset class. The degradation in liquidity is even more severe whenever both funds follow the same benchmark. Furthermore, increasing the number of ETFs in an asset class does not put downward pressure on expense ratios. Thus, decreasing market quality, enumerated by increasing bid-ask spreads and price impacts, is not offset by decreasing costs of fund ownership – resulting in a loss of surplus for investors and incumbent ETF providers.