Indexers and Co-Movement

Abstract

I introduce a general equilibrium model with active investors and indexers. The presence of indexers causes market segmentation, and the degree of segmentation is linked to the relative wealth of indexers in the economy. Any shock to this relative wealth generates excess comovement by inducing correlated shocks to discount rates of index stocks. The wealthier the indexers are, the greater the resulting excess comovement is. In the data, I find that S&P 500 stocks tend to comove more with other index stocks and less with non-index stocks, but this was not the case until the 1970s when indexing gained in popularity. I use passive holdings of S&P 500 stocks as a proxy for the wealth of indexers and find that changes in passive holdings are positively related to changes of excess comovement in S&P 500 stocks.