Index-Linked Trading and Stock Returns
68 Pages Posted: 26 Apr 2021 Last revised: 29 Aug 2023
Date Written: August 28, 2023
I consider a model of index-linked trading in which a fraction of investors trade an index product that holds the market portfolio (e.g., an ETF). Other investors build portfolios by evaluating stocks individually. Investors are equally informed and choose portfolios to maximize their expected utility. In equilibrium, price impact from trading the index product is not equal across stocks. Index-linked trade generates cross sectional differences in returns and volatilities. Furthermore, uncertainty about indexing demand generates risk premiums in expected returns and their magnitudes depend on firm fundamentals. The findings lend a theoretical foundation to existing studies and I provide empirical support for new predictions.
Keywords: Index investing, price impact, cross section of returns, risk premium
JEL Classification: G12, G14
Suggested Citation: Suggested Citation