“Informed trading, indexing, and welfare” by Prof. Diego Garcia
The University of Colorado Boulder
We study the implications of informed trading for the welfare of market participants within the canonical rational expectations model (Grossman and Stiglitz (1980), Hellwig (1980)). We find that as the informed population grows, or their signals become more precise, uninformed investors' welfare falls. We extend the model to allow for multiple assets, in order to study the consequences of indexing, i.e., committing to invest in risky assets only via the market portfolio. We show that indexing imposes a negative externality on agents. More indexing makes informed trading in the market more profitable, which decreases welfare by distorting risk-sharing.