Abstract
We provide a theoretical analysis of how index investing affects capital market equilibrium. We consider a dynamic exchange economy with heterogeneous investors and two Lucas trees and find that the introduction of index trading increases volatilities and correlation of stock returns. Contrary to conventional wisdom, these effects mainly result from improved risk sharing rather than from lockstep trading of stocks implied by indexing. Despite the residual market incompleteness, index investing increases welfare of investors previously excluded from financial markets so that it becomes close to its first-best level in the economy in which all investors trade individual assets.
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