Does Stock Indexing Impede or Facilitate Arbitrage and Price Discovery?

What is the effect of stock indexing on information arbitrage and the efficacy of the price discovery process? Forty-five years after John C. Bogle, the Vanguard Group founder, launched the world’s first index mutual fund, and 30 years after the debut of State Street’s S&P 500 ETF on Jan. 22, 1993, index investing continues to grow.

The rise of stock indexing has reshaped investing by democratizing access to low-cost passive strategies. Yet, it has also raised concerns that stock indexing impedes arbitrage and degrades price discovery. The conventional argument is that indexing is akin to free riding on other people’s research since index investors rely on prices without contributing to price discovery. The replacement of active investors with index investors, the argument goes, impedes price discovery and reduces price efficiency. A related argument is that basket trading, i.e., the mass buying or selling of index constituents, amplifies return volatility and decreases stock liquidity for the underlying index constituents. This argument implies that index investing increases the cost and risk of information arbitrage, thereby reducing price efficiency.

To the contrary, index products provide efficient means to transfer risk and hedge. Arbitrageurs routinely use index products as building blocks of active strategies that allow them to bet more aggressively on firm-specific information while hedging out systematic exposure. In addition, indexing can improve arbitrageurs’ ability to take short positions and exploit inefficiencies. This is because index funds control a large portion of the inventory of lendable stock and typically participate in securities lending programs. Indeed, low-cost index funds use stock-loan fees generated from such programs to enhance fund performance and offset fees for index investors. For example, Vanguard has a dynamic approach to stock lending dubbed “value lending” that is designed to capture a scarcity premium found in hard-to-borrow stocks.

Sorting out causation from association is important in the debate surrounding the rise of index investing. Simply put, the issue is that stocks with different levels of ownership by index funds may differ along fundamental dimensions that are related to stock liquidity, the severity of short-sales constraints, and the overall efficacy of the price discovery process. To identify the effect of indexing on arbitrage conditions and price discovery, we use FTSE Russell’s index reconstitution as a source of exogenous variation in index investing. The Russell reconstitution follows rules based on market-cap breakpoints and a transparent timeline.

With trillions of dollars of capital pegged to Russell’s indexes, the annual reconstitution is one of the busiest trading days of the year due to the forced buying and selling of stocks. A key feature of the Russell reconstitution is that small and random differences in market cap can move stocks between indexes and cause large and discontinuous changes in index investing at reconstitution. Our paper offers a granular analysis of stock lending dynamics for additions and deletions to the reconstituted Russell indices.

While our evidence shows that exogenous variation in index investing has no discernible effects at Russell’s index reconstitution cutoff separating large- and mid-cap stocks from small-cap stocks, we find significant addition and deletion reconstitution effects at the lower cutoff separating small- from micro-cap stocks. Micro-cap stock additions to the popular Russell 2000 index experience a relaxation of stock lending constraints, an improvement in liquidity, and an increase in the speed of price adjustment to news. On the flip side, micro-cap stock deletions from the Russell 2000 experience a tightening of stock lending constraints, a deterioration in liquidity, and a decrease in the speed of price adjustment to news. The evidence further shows that an exogenous increase in index investing facilitates the timelier incorporation of news, especially for micro-cap stocks that are harder to borrow and harder to trade prior to their reconstitution into the Russell 2000.

Our evidence identifies the relaxation of arbitrage constraints as an important mechanism through which indexing can facilitate information arbitrage and increase price efficiency for more arbitrage-constrained micro-cap stocks. To be clear, we do not argue that there is only a bright side to stock indexing. A growing concern about stock indexing is the concentration of ownership and voting power among the “Big Three” index fund managers: Vanguard, BlackRock, and State Street. Concentration among the Big Three is the subject of a debate about the future of corporate governance.  While it might be too early to resolve this debate, the issue deserves the attention of policy makers. At the same time, policy makers may need to resist a hasty regulatory response before the effect of stock indexing on information arbitrage and price discovery is more fully understood.

This post comes to us from Panos N. Patatoukas, the L.H. Penney Chair in Accounting at the University of California, Berkeley,  and Byung Hyun Ahn of Dimensional Fund Advisors. It is based on their paper, “Identifying the Effect of Stock Indexing: Impetus or Impediment to Arbitrage and Price Discovery?” published in the Journal of Financial & Quantitative Analysis and available here.