Essays on Index Investing

Abstract

This dissertation consists of two chapters about the economic consequences of index investing. The first chapter examines the impact of index investing on short selling. Short sellers convey negative information to securities lenders when borrowing shares. I model how this information generates novel interactions between institutional investors’ equilibrium lending, trading, and governance decisions. Index funds lenders cannot trade on lending market information, allowing them to attract more shorting demand and thereby improve price efficiency—despite increasing lending fees. The second chapter explores how index investing impacts managerial compensation in a moral hazard setting. With index investing, effort is reflected not only in the manager’s stock price but also in the stock prices of all other constituent firms through the synchronized asset demands of index investors. Thus, the prices of other constituent firms are positively related to and contain unique information about the manager’s effort. The optimal contract puts a positive weight on the index’s price to enhance the effort sensitivity of the manager’s pay, not to reduce risk.