The Economic Impact of Index Investing

We study the impact of index investing on firm performance by examining the link between commodity indices and firms that use index commodities. Around 2004, commodity index investing dramatically increased. This event is referred to as the financialization of commodity markets. Following financialization, firms that use index commodities make worse production decisions, earn 40% lower profits, and have 6% higher costs. Consistent with a feedback channel in which market participants learn from prices, our results suggest that index investing distorts the price signal, thereby generating a negative externality that impedes firms’ ability to make production decisions. Received March 31, 2017; editorial decision July 5, 2018 by Editor Itay Goldstein. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Is Commodity Index Investing Profitable?

Using a comprehensive dataset of first-, second-, and third-generation commodity indices, we investigate the potential diversification benefits in equity-bond portfolios. The results show that first-generation commodity indices are outperformed by enhanced indices. Second-generation indices provide slightly increased portfolio Sharpe ratios but at the same time they are spanned by benchmark assets. For third-generation commodity indices, the mean-variance spanning hypothesis is rejected but they show heterogenous out-of-sample performances. We thus present new evidence showing that the performance of the third-generation of commodity indices is less clear-cut than found in existing studies.