Index Portfolio and Welfare Analysis under Heterogeneous Beliefs

Abstract

With a growing popularity of index funds, we adopt a differences-in-opinion, general equilibrium framework to examine theoretically whether investors are better off with an index portfolio than active investing. In contrary to the conventional view, we find that, even for an active investor with the most accurate belief, switching to an index portfolio can significantly improve his expected ex-post welfare when the active investors have incorrect beliefs or face incomplete information. Moreover, the welfare improvement becomes more substantial when the active investors are more risk averse.

Keywords: Index funds; Active investing; Welfare analysis; Differences in opinion; General equilibrium model

JEL Classification: G11, G12, D84