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We investigate the causal effects of passive investing on informational efficiency and market quality metrics by developing a novel laboratory experiment that introduces Index trackers with exogenous passive investment flows. We find that, while improving liquidity, Index tracking hurts informational efficiency, confirming our main hypothesis. Furthermore, we observe violations of the law of one price, leading to widespread and persistent arbitrage opportunities. Additionally, our research uncovers that Active traders, particularly those with private information about asset values and high cognitive ability, reap benefits from the introduction of Index tracking.


ESI Working Paper 24-02



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