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
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: Suggested Citation