PRODUCT DIFFERENTIATION, EARCH COSTS, AND COMPETITION IN THE MUTUAL FUND INDUSTRY: A CASE STUDY OF S&P 500 INDEX FUNDS by Ali Hortaçsu and Chad Syverson

PRODUCT DIFFERENTIATION, SEARCH COSTS, AND COMPETITION IN THE MUTUAL FUND INDUSTRY: A CASE STUDY OF S&P 500 INDEX FUNDS by Ali Hortaçsu and Chad Syverson

I. Introduction
An investor seeking to hold assets in a mutual fund is a consumer with many choices: in 
2001, there were 8307 U.S. mutual funds in operation. If one counts different share classes for a 
common portfolio as separate options available to an investor, the implied total number of funds 
to choose from exceeds 13,000. Note in comparison that there were a total of 7600 companies 
listed that year on the NYSE, AMEX, and Nasdaq combined. A mutual fund investor’s choice 
set has also been growing robustly over time: while there were 834 mutual funds in operation in 
1980, this nearly quadrupled to 3100 by 1990, and almost tripled again by 2001.
An additional, less documented feature of the mutual fund marketplace is the enormous 
dispersion in the fees investors pay to hold assets in funds, a dispersion that persists despite the 
competition among large number of industry firms. These fee differences are not simply a result 
of variation across fund sectors; price dispersion within (even narrowly defined) sectors is large. 
Table 1 summarizes this within-sector dispersion. The table shows fund fee dispersion 
moments—the coefficient of variation, the interquartile price ratio, and the ratio of the 90th to the 
10th percentile price—for each of 22 fund objective sectors in 2000.
As is evident in the table, the 75th-percentile-price fund in a sector-year cell typically has 
investor costs about twice those of the 25th percentile fund. The 90th-10th percentile price ratios 
indicate between three- and seven-fold fee differences within sector-years. The extrema of the 
distribution (not shown) can exhibit vast dispersion; the minimum-price aggressive growth fund, 
for example, imposed annualized fees of only 14 basis points (i.e., 0.14% of the value of an 
investor’s assets in the fund), whereas the highest-price fund charged a whopping 1670 basis 
points. While some of these sectors are fairly broad and may include funds with very different 
portfolios, dispersion remains even within what are plausibly quite specialized sectors. The 
table’s second panel shows the same dispersion measures for four randomly selected specialized 

sectors (these are based on Strategic Insight’s classification system, which is considerably finer 
than the above taxonomy). There is a modest drop in price dispersion compared to the broader 
sectors, but considerable differences still remain.
Of course, fund portfolios can vary considerably even within narrow asset classes. Fund 
price dispersion might then reflect within-sector differences in demand or cost structures across 
portfolios. On the demand side, certain portfolios will outperform their sector cohorts; higher 
prices may just reflect investors’ willingness to pay for better performance. As for costs, fund 
managers choose different securities with which to comprise their portfolio, and some of these 
securities may be more expensive to analyze or trade than others. Fund prices may reflect this 
fact.
 Portfolio differentiation, too, may explain in part the other salient fact discussed above: the 
large number of industry funds. Investors may differ in their ideal portfolios and their current 
asset compositions. Perhaps thousands of funds (and the several hundred new funds each year) 
are necessary to meet the demand for the many risk-return profiles sought by investors.
However, a look at the retail (i.e., non-institutional) S&P 500 index fund sector strongly 
suggests that the composition and financial performance of funds’ portfolios are not the only 
factors explaining fund proliferation and fee dispersion. All funds in this $164 billion (in 2000) 

PRODUCT DIFFERENTIATION, SEARCH COSTS, AND COMPETITION IN THE MUTUAL FUND INDUSTRY: A CASE STUDY OF S&P 500 INDEX FUNDS by Ali Hortaçsu and Chad Syverson