We theoretically analyze how index investing affects financial markets using a dynamic exchange economy with heterogeneous investors and two Lucas trees. We identify two effects of indexing: lockstep trading of stocks increases market volatility and stock return correlations but reduction in risk sharing decreases them. Overall, indexing decreases market volatility but has an ambiguous effect on the correlations. Also, index investing decreases an investor’s welfare, but indexing by other investors partially offsets the loss. When the introduction of index trading opens financial markets for new investors, the improved risk sharing makes market returns more volatile and stock returns more correlated.
Financial Markets Group Discussion Papers DP 806
Paul Woolley Centre Discussion Papers No 68