Index Investing and Sentiment Spillover

Abstract

We develop a dynamic model of index investing that can reconcile key cross-sectional differences between index and non-index stocks. In our model, investors with extrapolative expectations create sentiment, and index investing spills the sentiment on an index stock to all other index stocks. Primarily due to this spillover mechanism, we find that when index investors are mostly extrapolators, all consistent with empirical evidence, index stocks have higher and more volatile prices, comove more with other index stocks, exhibit stronger negative price autocorrelation, and have higher trading volume than comparable non-index stocks. Our model also reconciles the recently observed "disappearing index effect" and delivers novel implications on the flow-performance relation for index funds, the response of investor portfolios to their subjective beliefs, and the welfare costs of index investing.

Keywords: sentiment spillover, extrapolative expectations, comovement, passive fund flows, attenuation, Index investing

JEL Classification: G11, G12, D53