Do Index Funds Benefit Investors?

Abstract

The short answer is “Maybe not.” To demonstrate this possibility, we construct and study two models in which investors choose among bonds, individual stocks, and an index Fund that holds the market portfolio. Asset prices are determined endogenously. The availability of the Fund induces investors to shift out of individual stocks and bonds and into the Fund.
The former shift reduces investor risk and increases investor welfare; the latter shift increases asset prices and decreases investor welfare. In a variety of settings, we show that the net effect is that availability of the Fund decreases welfare for some – even all – investors.