The Value of ETF Liquidity

We model how ETFs compete and set fees. We show that ETF secondary market liquidity plays a key role in determining fees and leads to liquidity clienteles. More liquid ETFs charge higher fees in equilibrium and attract shorter horizon investors that are more sensitive to liquidity than to fees. The higher turnover of these investors sustains the ETF's high liquidity, allowing the ETF to maintain a higher fee and extract a rent. These liquidity rents create a first-mover advantage among ETFs and impact investor welfare. Our empirical tests confirm the presence of liquidity clienteles and show that ETF fee differentials provide a novel measure of the value of liquidity. Our findings resolve the apparent paradox that ETFs with higher fees than their competitors can not only survive, but flourish in equilibrium due to the value of liquidity.