On Index Investing

Abstract

We quantify the impact of index investing on stock prices. Using a regression discontinuity analysis around yearly Russell index reconstitutions, we find that index investing introduces noise into stock prices, but does not impact long-term price efficiency or trading by arbitrageurs. Stocks with more index investors have prices that deviate more from a random walk and exhibit higher correlations with index price movements. However, these stocks have no difference in turnover, trading volume, or earnings response coefficients. In other words, index investing introduces noise into prices, but it does not impact the ability of arbitrageurs to impound information into prices.

Keywords: Active Management, Index Investing, Market Efficiency, Passive Management

JEL Classification: G12, G14