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Identifying the Effect of Stock Indexing: Impetus or Impediment to Arbitrage and Price Discovery?

Published online by Cambridge University Press:  08 April 2021

Byung Hyun Ahn  and
Panos N. Patatoukas Open the ORCID record for Panos N. Patatoukas [Opens in a new window]
Byung Hyun Ahn
Affiliation:
University of California, Berkeley, Haas School of Business byunghyun_ahn@haas.berkeley.edu
Panos N. Patatoukas*
Affiliation:
University of California, Berkeley, Haas School of Business
*
panos@haas.berkeley.edu (corresponding author)
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Abstract

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The rise of stock indexing has raised concerns that index investing impedes arbitrage and degrades price discovery. This article uses Russell’s reconstitution to identify the causal effect of index investing on information arbitrage and price discovery. Although index investing has no discernible effect on the ability of arbitrageurs to trade and impound news into the prices of large- and mid-cap stocks, we find that index investing increases the speed of price adjustment to news for micro-cap stocks. Our causal evidence identifies the relaxation of arbitrage constraints as a mechanism through which indexing facilitates informed trading for more arbitrage-constrained micro-cap stocks.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 57 , Issue 5 , August 2022 , pp. 2022 - 2062
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted re-use, distribution, and reproduction in any medium, provided the original work is properly cited.
Copyright
© The Author(s), 2021. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank FTSE Russell’s Client Service associates and regional managers, especially Mallory Denney, for providing the Russell 3000E index constituent data and index reconstitution market-cap breakpoints. We thank FactSet and its research staff for providing the institutional ownership data. We thank Sebastian Calonico for helpful advice with regression discontinuity design (RDD) applications. We also thank an anonymous referee, Jennifer Conrad (the editor), John Core, Omri Even-Tov, Kimmie George, Marc Painter, Jacob Ma-Weaver, Mike Wilkins, and the PhD students at Berkeley Haas for helpful comments and discussions. We gratefully acknowledge financial support from the Center for Financial Reporting and Management at Berkeley Haas.

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