Tracking Biased Weights: Asset Pricing Implications of Value-Weighted Indexing
61 Pages Posted: 23 Dec 2020
Date Written: December 2020
We show theoretically and empirically that flows into index funds raise the prices of large stocks in the index disproportionately more than the prices of small stocks. Conversely, flows predict a high future return of the small-minus-large index portfolio. This finding runs counter to the CAPM, and arises when noise traders distort prices, biasing index weights. When funds tracking value-weighted indices experience inflows, they buy mainly stocks in high noise-trader demand, exacerbating the distortion. During our sample period 2000-2019, a small-minus-large portfolio of S&P500 stocks earns ten percent per year, while no size effect exists for non-index stocks.
JEL Classification: G10, G11, G12, G23
Suggested Citation: Suggested Citation