Abstract
AbstractThe rise of stock indexing has raised concerns that index investing impedes arbitrage and degrades price discovery. This article uses Russell’s reconstitution to identify the causal effect of index investing on information arbitrage and price discovery. Although 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.
Highlights
What is the effect of stock indexing on information arbitrage and the efficacy of the price-discovery process? Forty-three years after John C
We use the annual Russell reconstitution to identify the causal effect of stock indexing on information arbitrage and price discovery
Our evidence shows that exogenous variation in index investing has no discernible effects at the upper cutoff separating large- and mid-cap stocks from small-cap stocks, we find significant addition and deletion effects at the lower cutoff separating small- from micro-cap stocks
Summary
What is the effect of stock indexing on information arbitrage and the efficacy of the price-discovery process? Forty-three years after John C. Our evidence from micro-cap stock additions at the lower cutoff of the Russell 2000 shows that higher price synchronicity due to an exogenous increase in index investing reflects the earlier resolution of uncertainty through the timelier incorporation of news rather than a decrease in price informativeness. Different from prior association studies, our article provides new evidence on the causal effect of index investing on arbitrage conditions, price synchronicity, and the speed of price adjustment to market, industry, and firm news. We find strong evidence that index investing facilitates informed trading and increases the speed of price adjustment to news for micro-cap stocks, those that are more arbitrage constrained (i.e., stocks that are more illiquid and harder to borrow). Our evidence shows that exogenous variation in index investing is impactful at the lower cutoff of the Russell 2000 because micro- and small-cap stocks are significantly more arbitrage constrained relative to mid- and large-cap stocks at the upper cutoff of the Russell 2000
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