Research

The shift from active to passive investing has moved more than a quarter of the U.S. stock market into portfolios that track benchmarks. Measuring the realized indexed ownership of each stock from its holdings with the Indexing Inclusion Ratio (IXI), I find the most heavily indexed stocks are priced to earn about 1.6 percentage points per year less than the least indexed, yet they were among the strongest performers of the passive era. These two facts are one mechanism at two margins, because indexed ownership grew faster than prices had incorporated and realized returns absorbed the surprise as it arrived. S&P 500 inclusions price the channel at about 2 percent per percentage point of new indexed ownership, close to the standing premium that capitalizes the wedge. Those gains were the transition. The lower expected return is the price of passive ownership going forward.

We develop a demand-system asset pricing model in which investors differ both in beliefs about climate-adjusted returns and in perceived exposure to nontradable climate background risk. The belief channel operates through subjective expected returns. The hedging channel generates portfolio demand for climate insurance that does not respond to prices within the static model. In equilibrium, this hedging motive adds a third term to the brown-minus-green return spread beyond market risk and belief differences. The model's most distinctive prediction is cross-sectional: stocks with larger absolute climate correlation become more dominated by hedging demand, whether they are green or brown. A quantitative illustration shows that the mechanism produces plausible shifts in return spreads and demand composition under illustrative parameterizations.