The Impact of ETF Index Inclusion on Stock Prices

Abstract

A growing body of evidence suggests that assets included in market indexes trade at a premium relative to excluded assets. Here we look for evidence of such an index inclusion premium in a carefully controlled laboratory experiment. Our environment involves three assets and an Exchange Traded Fund (ETF) index asset. We model Authorized Participants (APs) as bots that create and redeem ETF shares by scanning the order books of the underlying assets. In one treatment, all three assets are included in the ETF index asset. In a second treatment, one of the three assets is excluded from the ETF index and is replaced by a second unit of one of the included assets; the included and excluded assets have identical fundamental values enabling a clean test of whether there exists an index inclusion premium. In a further variant of the excluded asset treatment, short-selling is allowed. We find that inclusion of an asset in the ETF index results in a substantial price premium. This is due to investors' strong demand for the ETF asset and use of a buy-and-hold strategy that reduces the tradeable supply of the assets that underlie the ETF asset and increases their price. Short-selling helps to alleviate the supply problem, but given the strong demand for the ETF asset, the inclusion premium persists.

Keywords: index premium, ETFs, experimental finance

JEL Classification: G11, G12, G14, C92