Asset Pricing with Index Investing
London School of Economics and Political Science
Temple University - Department of Finance
August 6, 2015
Fox School of Business Research Paper No. 15-051
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, contrary to common beliefs, indexing can decrease the correlation between stock returns. It also decreases market volatility and interest rates, typically increases (decreases) volatilities and betas of large (small) stocks, but has almost no effect on investors’ welfare. The impact of index investing is stronger when stocks have heterogeneous fundamentals. Our analysis highlights that indexing changes not only how investors can trade but also their incentives to trade.
Number of Pages in PDF File: 55
Keywords: asset pricing, general equilibrium, index investing, heterogeneous investors, Lucas trees
