The Equilibrium Consequences of Indexing

We develop a benchmark model to study the equilibrium consequences of indexing in a standard rational expectations setting (Grossman and Stiglitz (1980); Hellwig (1980); Diamond and Verrecchia (1981)). Individuals must incur costs to participate in financial markets, and these costs are lower for individuals who restrict themselves to indexing strategies. Individuals’ participation decisions exhibit strategic complementarity. As indexing becomes cheaper (1) indexing increases, while individual stock trading decreases; (2) aggregate price efficiency falls, while relative price efficiency increases; (3) the welfare of relatively uninformed traders increases; (4) for well-informed traders, the share of trading gains stemming from market timing increases, and the share of gains from stock selection decreases; (5) market-wide reversals become more pronounced. We discuss empirical evidence for these predictions.