Index-Linked Trading and Stock Returns

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). The remaining 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.