Are ETFs better than Mutual Funds? 

Abstract

I study investors' trade-off between ETFs and open-end 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. This result challenges the conventional argument that ETFs are tailored towards liquidity traders because of their intra-day trading. It emerges however directly from the differential frictions of ETFs and mutual funds. Over the long-term, externalities between mutual fund investors dilute fund holdings and generate underperformance vis-à-vis ETFs. Yet, due to their exchange traded nature and dependence on arbitrage by intermediaries, in the short-run ETFs can trade at a discount relative to mutual funds. Overall, ETFs are not predicted to fully replace index mutual funds because both fund types provide complementary liquidity provision services.