Index Funds, Asset Prices, and the Welfare of Investors

We present a general equilibrium model in which heterogeneous investors choose among bonds, stocks, and an Index Fund holding the market portfolio. We show that, under standard assumptions, an equilibrium exists. We then derive predictions for equilibrium asset prices, investor behavior, and investor welfare. The presence of the index fund (or a decrease in the fee charged by the index fund) tends to increase stock market participation and thus increase asset prices and decrease expected returns from investing in the stock market. As a result, few - if any - investors benefit from the availability of cheap market indexing