When it comes to exchange-traded funds (ETFs), more is not merrier.
“The addition of new funds to a particular segment radically increases both the costs and the price impact of trading.”Unlike most market situations, where increased competition puts downward pressure on prices, the costly process of buying and redeeming ETFs shares through an exchange mitigates the benefits, according to research by Assistant Professor Travis Box, Ph.D candidate Ryan Davis, and Associate Professor Kathleen Fuller of the University of Mississippi.
The results of the trio’s study “provide no evidence that investors benefit when the number of competitors rises.” In fact, the researchers found incumbent fund managers raised, rather than lowered, prices in the face of competition.
“The addition of new funds to a particular segment radically increases both the costs and the price impact of trading,” they wrote.
Currently, more than $3 trillion in assets are allocated to ETFs. Cerulli Associates predicted that number would double by 2020, with a growing number of asset managers entering the market.
“With more asset managers developing an ETF strategy, product proliferation will continue to increase,” said Jennifer Muzerall, senior analyst at Cerulli.
But as the number of identical funds increases, the overall market quality will decrease as liquidity for the incumbent funds “dries up,” according to the University of Mississippi research.
“This implies that bid/ask spreads would likely widen and the cost of placing large orders… would likely increase,” they wrote. “In this case, even more investor and manager surplus is consumed by trading fictions, and a much larger portion of their combined surplus is completely lost to forgone investing.”
The more ETFs in a given category, the more pronounced these effects, as the pool of investors providing liquidity is further fragmented. Therefore, investors might be better off with more specialized funds—such as active ETFs or smart beta products—than with a standard index-tracker.
But given that even smart beta ETFs numbered close to 800 at the end of 2015, according to ETFGI, the downsides of competition might be hard to escape.
“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 ETF providers,” the researchers concluded.
Related: The $3 Trillion ETF ‘Boom’ & ETF Assets to Surpass $6 Trillion by 2020