Hostname: page-component-78c5997874-lj6df Total loading time: 0 Render date: 2024-11-15T20:42:39.608Z Has data issue: false hasContentIssue false
  • English
  • Français

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)
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.

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.

References

Ali, A.; Hwang, L. S.; and Trombley, M. A.. “Arbitrage Risk and the Book-to-Market Anomaly.” Journal of Financial Economics , 69 (2003), 355–373.CrossRefGoogle Scholar
Amihud, Y. “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects.” Journal of Financial Markets , 5 (2002), 31–56.CrossRefGoogle Scholar
Appel, I. R.; Gormley, T. A.; and Keim, D. B.. “Passive Investors, Not Passive Owners.” Journal of Financial Economics , 121 (2016), 111–141.CrossRefGoogle Scholar
Appel, I. R.; Gormley, T. A.; and Keim, D. B.. “Standing on the Shoulders of Giants: The Effect of Passive Investors on Activism.” Review of Financial Studies , 32 (2019), 2720–2774.CrossRefGoogle Scholar
Appel, I. R.; Gormley, T. A.; and Keim, D. B.. “Identification Using Russell 1000/2000 Index Assignments: A Discussion of Methodologies.” Critical Finance Review , forthcoming (2021).Google Scholar
Bakke, T. E., and Whited, T. M.. “Threshold Events and Identification: A Study of Cash Shortfalls.” Journal of Finance , 67 (2012), 1083–1111.CrossRefGoogle Scholar
Barberis, N.; Shleifer, A.; and Wurgler, J.. “Comovement.” Journal of Financial Economics , 75 (2005), 283–317.CrossRefGoogle Scholar
Battistin, E.; Brugiavini, A.; Rettore, E.; and Weber, G.. “The Retirement Consumption Puzzle: Evidence from a Regression Discontinuity Approach.” American Economic Review , 99 (2009), 2209–2226.CrossRefGoogle Scholar
Bebchuk, L., and Hirst, S.. “The Specter of the Giant Three.” Boston University Law Review , 99 (2019), 721–741.Google Scholar
Ben-David, I.; Franzoni, F.; and Moussawi, R.. “Do ETFs Increase Volatility?” Journal of Finance , 73 (2018), 2471–2535.CrossRefGoogle Scholar
Ben-David, I.; Franzoni, F.; and Moussawi, R.. “A Note to ‘Do ETFs Increase Volatility?’: An Improved Method to Predict Assignment of Stocks into Russell Indexes.” NBER Working Paper (2019).Google Scholar
Bhojraj, S.; Mohanram, P. S.; and Zhang, S.. “ETFs and Information Transfer across Firms.” Journal of Accounting and Economics, 70 (2020), 101336.CrossRefGoogle Scholar
Blocher, J., and Whaley, R. E.. “Passive Investing: The Role of Securities Lending.” Working Paper, Vanderbilt Owen Graduate School of Management (2015).Google Scholar
Boone, A. L., and J. T. White. “The Effect of Institutional Ownership on Firm Transparency and Information Production.” Journal of Financial Economics , 117 (2015), 508–533.CrossRefGoogle Scholar
Bushee, B. J. “The Influence of Institutional Investors on Myopic R&D Investment Behavior.” Accounting Review , 73 (1998), 305–333.Google Scholar
Calonico, S.; Cattaneo, M. D.; and Titiunik, R.. “Robust Nonparametric Confidence Intervals for Regression-Discontinuity Designs.” Econometrica , 82 (2014), 2295–2326.CrossRefGoogle Scholar
Calonico, S.; Cattaneo, M. D.; and Titiunik, R.. “rdrobust: An r Package for Robust Nonparametric Inference in Regression-Discontinuity Designs.” R Journal , 7 (2015), 38–51.CrossRefGoogle Scholar
Cao, C. M.; Gustafson, M.; and Velthuis, R.. “Index Membership and Small Firm Financing.” Management Science , 65 (2019), 4156–4178.CrossRefGoogle Scholar
Cattaneo, M. D.; Idrobo, N.; and Titiunik, R.. A Practical Introduction to Regression Discontinuity Designs . Cambridge, UK: Cambridge University Press (2017).CrossRefGoogle Scholar
Chabakauri, G., and Rytchkov, O.. “Asset Pricing with Index Investing.” Journal of Financial Economics , 141 (2021), 195–216.CrossRefGoogle Scholar
Chan, K., and Hameed, A.. “Stock Price Synchronicity and Analyst Coverage in Emerging Markets.” Journal of Financial Economics , 80 (2006), 115–147.CrossRefGoogle Scholar
Chang, Y. C.; Hong, H.; and Liskovich, I.. “Regression Discontinuity and the Price Effects of Stock Market Indexing.” Review of Financial Studies , 28 (2015), 212–246.CrossRefGoogle Scholar
Coles, J. L.; Heath, D.; and Ringgenberg, M.. “On Index Investing.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3055324 (2020).Google Scholar
D’Avolio, G. “The Market for Borrowing Stock.” Journal of Financial Economics , 66 (2002), 271–306.CrossRefGoogle Scholar
Da, Z., and Shive, S.. “Exchange Traded Funds and Asset Return Correlations.” European Financial Management , 24 (2018), 136–168.CrossRefGoogle Scholar
Diamond, D. W., and Verrecchia, R. E.. “Constraints on Short-Selling and Asset Price Adjustment to Private Information.” Journal of Financial Economics , 18 (1987), 277–311.CrossRefGoogle Scholar
Durnev, A.; Morck, R.; and Yeung, B.. “Value-Enhancing Capital Budgeting and Firm-Specific Stock Return Variation.” Journal of Finance , 59 (2004), 65–105.CrossRefGoogle Scholar
Easley, D.; Michayluk, D.; O’Hara, M.; and Putniņš, T. J.. “The Active World of Passive Investing.” Review of Finance, 25 (2021), 1433–1471.Google Scholar
Engelberg, J. E.; Reed, A. V.; and Ringgenberg, M. C.. “Short-Selling Risk.” Journal of Finance , 73 (2018), 755–786.CrossRefGoogle Scholar
Fisch, J. E.; Hamdani, A.; and Solomon, S. D.. “The New Titans of Wall Street: A Theoretical Framework for Passive Investors.” University of Pennsylvania Law Review , 168 (2019), 17–72.Google Scholar
Gao, X., and Ritter, J. R.. “The Marketing of Seasoned Equity Offerings.” Journal of Financial Economics , 97 (2010), 33–52.CrossRefGoogle Scholar
Gelman, A., and Imbens, G.. “Why High-Order Polynomials Should Not Be Used in Regression Discontinuity Designs.” Journal of Business and Economic Statistics , 37 (2019), 447–456.CrossRefGoogle Scholar
Glossner, S. “Russell Index Reconstitutions, Institutional Investors, and Corporate Social Responsibility.” Critical Finance Review , forthcoming (2021).Google Scholar
Glosten, L.; Nallareddy, S.; and Zou, Y.. “ETF Activity and Informational Efficiency of Underlying Securities.” Management Science, 67 (2021), 22–47.CrossRefGoogle Scholar
Grossman, S. J., and Stiglitz, J. E.. “On the Impossibility of Informationally Efficient Markets.” American Economic Review , 70 (1980), 393–408.Google Scholar
Hamm, S. “The Effect of ETFs on Stock Liquidity.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1687914 (2014).Google Scholar
Harris, L., and Gurel, E.. “Price and Volume Effects Associated with Changes in the S&P 500 List: New Evidence for the Existence of Price Pressures.” Journal of Finance , 41 (1986), 815–829.CrossRefGoogle Scholar
Heath, D.; Macciocchi, D.; Michaely, R.; and Ringgenberg, M.. “Do Index Funds Monitor?” Review of Financial Studies, forthcoming (2021).CrossRefGoogle Scholar
Hou, K., and Moskowitz, T. J.. “Market Frictions, Price Delay, and the Cross-Section of Expected Returns.” Review of Financial Studies , 18 (2005), 981–1020.CrossRefGoogle Scholar
Huang, S.; O’Hara, M.; and Zhong, Z.. “Innovation and Informed Trading: Evidence from Industry ETFs.” Review of Financial Studies, 34 (2021), 1280–1316.Google Scholar
Imbens, G., and Kalyanaraman, K.. “Optimal Bandwidth Choice for the Regression Discontinuity Estimator.” Review of Economic Studies , 79 (2012), 933–959.CrossRefGoogle Scholar
Investment Company Institute. “Investment Company Fact Book: A Review of Trends and Activities in the Investment Company Industry.” Available at https://www.ici.org/system/files/attachments/pdf/2020_factbook.pdf (2020).Google Scholar
Israeli, D.; Lee, C. M.; and Sridharan, S. A.. “Is There a Dark Side to Exchange Traded Funds? An Information Perspective.” Review of Accounting Studies , 22 (2017), 1048–1083.CrossRefGoogle Scholar
Krause, T.; Ehsani, S.; and Lien, D.. “Exchange-Traded Funds, Liquidity, and Volatility.” Applied Financial Economics , 24 (2014), 1617–1630.CrossRefGoogle Scholar
Lee, D. S., and Lemieux, T.. “Regression Discontinuity Designs in Economics.” Journal of Economic Literature , 48 (2010), 281–355.CrossRefGoogle Scholar
Li, F. W., and Zhu, Q.. “Short Selling ETFs.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2836518 (2019).Google Scholar
McCrary, J. “Manipulation of the Running Variable in the Regression Discontinuity Design: A Density Test.” Journal of Econometrics , 142 (2008), 698–714.CrossRefGoogle Scholar
Morck, R.; Yeung, B.; and Yu, W.. “The Information Content of Stock Markets: Why Do Emerging Markets Have Synchronous Stock Price Movements?” Journal of Financial Economics , 58 (2000), 215–260.CrossRefGoogle Scholar
Nagel, S. “Short Sales, Institutional Investors, and the Cross-Section of Stock Returns.” Journal of Financial Economics , 78 (2005), 277–309.CrossRefGoogle Scholar
Pei, Z., and Shen, Y.. “The Devil Is in the Tails: Regression Discontinuity Design with Measurement Error in the Assignment Variable.” Advances in Econometrics , 38 (2017), 455–502.CrossRefGoogle Scholar
Prado, M. P.; Saffi, P. A.; and Sturgess, J.. “Ownership Structure, Limits to Arbitrage, and Stock Returns: Evidence from Equity Lending Markets.” Review of Financial Studies , 29 (2016), 3211–3244.CrossRefGoogle Scholar
Roberts, M. R., and Whited, T. M.. “Endogeneity in Empirical Corporate Finance.” In Handbook of the Economics of Finance, Vol. 2, Constantinides, G., Harris, M., and Stulz, R., eds. Amsterdam, Netherlands: North Holland (2013).Google Scholar
Schmidt, C., and Fahlenbrach, R.. “Do Exogenous Changes in Passive Institutional Ownership Affect Corporate Governance and Firm Value?” Journal of Financial Economics , 124 (2017), 285–306.CrossRefGoogle Scholar
Shleifer, A. “Do Demand Curves for Stocks Slope Down?” Journal of Finance , 41 (1986), 579–590.CrossRefGoogle Scholar
Sullivan, R. N., and Xiong, J. X.. “How Index Trading Increases Market Vulnerability.” Financial Analysts Journal , 68 (2012), 70–84.CrossRefGoogle Scholar
Vanguard Group. “Under the Hood of Securities-Lending Practices.” Research and commentary (2018).Google Scholar
Vijh, A. M. “S&P 500 Trading Strategies and Stock Betas.” Review of Financial Studies , 7 (1994), 215–251.CrossRefGoogle Scholar
Wei, W., and Young, A.. “Selection Bias or Treatment Effect? A Re-Examination of Russell 1000/2000 Index Reconstitution.” Critical Finance Review , forthcoming (2021).Google ScholarPubMed
Wooldridge, J. M. Introductory Econometrics: A Modern Approach . Mason, OH: South-Western Cengage Learning (2012).Google Scholar
Zhang, X. F. “Information Uncertainty and Stock Returns.” Journal of Finance , 61 (2006), 105–137.CrossRefGoogle Scholar