Indexing and Stock Price Efficiency
Financial Management, Vol. 44, Issue 4, 875-904, 2015
46 Pages Posted: 19 Mar 2013 Last revised: 18 Feb 2016
Date Written: December 31, 2014
Indexing has experienced substantial growth over the last two decades because it is an effective way of holding a diversified portfolio while minimizing trading costs and taxes. In this paper, we focus on one negative externality of indexing: the effect on efficiency of stock prices. Based on a sample of large and liquid U.S. stocks, we find that greater indexing leads to less efficient stock prices, as indicated by stronger post-earnings-announcement drift and greater deviations of stock prices from the random walk. We conjecture that reduced incentives for information acquisition and arbitrage induced by indexing and passive trading are probably the main causes for degradation in price efficiency.
Keywords: indexing, index funds, ETFs, passive institutional investors, stock price efficiency, passive trading
JEL Classification: G14, G23
Suggested Citation: Suggested Citation