The Impact of ETF Index Inclusion on Stock Prices

38 Pages Posted: 6 Apr 2022 Last revised: 31 May 2022

See all articles by John Duffy

John Duffy

University of California, Irvine

Daniel Friedman

University of California, Santa Cruz - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Jean Paul Rabanal

University of Stavanger

Olga Rud

University of Stavanger

Date Written: May 24, 2022

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

Suggested Citation

Duffy, John and Friedman, Daniel and Rabanal, Jean Paul and Rud, Olga, The Impact of ETF Index Inclusion on Stock Prices (May 24, 2022). Available at SSRN: https://ssrn.com/abstract=4061686 or http://dx.doi.org/10.2139/ssrn.4061686

John Duffy

University of California, Irvine ( email )

Department of Economics
3151 Social Science Plaza
Irvine, CA 92697
United States
949-824-8341 (Phone)

Daniel Friedman

University of California, Santa Cruz - Department of Economics ( email )

Social Sciences I
Santa Cruz, CA 95064
United States
831-459-4981 (Phone)
831-459-5900 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

Jean Paul Rabanal

University of Stavanger ( email )

PB 8002
Stavanger, 4036
Norway

Olga Rud (Contact Author)

University of Stavanger ( email )

PB 8002
Stavanger, 4036
Norway

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