We theoretically analyze how index investing affects financial markets using a dynamic
exchange economy with heterogeneous investors and two Lucas trees. We identify two
effects of indexing: lockstep trading of stocks increases market volatility and stock return
correlations but reduction in risk sharing decreases them. Overall, indexing decreases
market volatility but has an ambiguous effect on the correlations. Also, index investing
decreases an investor's welfare, but indexing by other investors partially offsets the loss …

We provide a novel 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 indexing can either increase or decrease the correlation
between stock returns and in general increases (decreases) volatilities and betas of stocks
with larger (smaller) market capitalizations. Indexing also decreases market volatility and
interest rates, although those effects are weak. The impact of index investing is particularly …