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

Journal of Financial and Quantitative Analysis (JFQA)

59 Pages Posted: 26 Feb 2021 Last revised: 8 Nov 2021

See all articles by Byung Hyun Ahn

Byung Hyun Ahn

University of California, Berkeley - Haas School of Business

Panos N. Patatoukas

University of California, Berkeley - Haas School of Business

Date Written: September 6, 2019

Abstract

The rise of stock indexing has raised concerns that index investing impedes arbitrage and degrades price discovery. This paper uses Russell’s reconstitution to identify the causal effect of index investing on information arbitrage and price discovery. While 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.

Keywords: Stock Indexing, Information Arbitrage, Price Discovery, Russell Reconstitution

JEL Classification: G12, G14, G23, M41

Suggested Citation

Ahn, Byung Hyun and Patatoukas, Panos N., Identifying the Effect of Stock Indexing: Impetus or Impediment to Arbitrage and Price Discovery? (September 6, 2019). Journal of Financial and Quantitative Analysis (JFQA), Available at SSRN: https://ssrn.com/abstract=3753637 or http://dx.doi.org/10.2139/ssrn.3753637

Byung Hyun Ahn

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States

Panos N. Patatoukas (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States

HOME PAGE: http://https://sites.google.com/berkeley.edu/panos

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