Are ETFs better than Mutual Funds?

Anna-Theresa Helmke, PhD Candidate at the Wharton School

Abstract: I study investors’ trade-off between ETFs and open-ended mutual funds in the presence of idiosyncratic liquidity risk and aggregate uncertainty. Based on a portfolio choice model, I show that ETFs and mutual funds provide liquidity at different maturities. Mutual funds (ETFs) are preferred by investors facing high (low) idiosyncratic liquidity risk and shorter (longer) investment horizons. In equilibrium, the pooling of investors into fund types based on their expected investment horizon directly emerges from the differential frictions of ETFs and mutual funds. Over the long-term, payoff complementarities in mutual funds dilute investors fund holdings and generate underperformance vis-à-vis ETFs. Yet, in the short-run, ETFs can be mispriced due to intermediary arbitrage constraints. The optimal size of the mutual fund sector relative to ETFs decreases in the illiquidity of portfolio assets but increases in the proportion of mutual fund shares held via retirement accounts.