Tracking Biased Weights: Asset Pricing Implications of Value-Weighted Indexing

Dimitri Vayanos, Hao Jiang and Lu Zheng

No 15563, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: 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.

Keywords: Market efficiency; Mutual funds; Indexing; Limits of arbitrage (search for similar items in EconPapers)
JEL-codes: G10 G11 G12 G23 (search for similar items in EconPapers)
Date: 2020-12
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Working Paper: Tracking biased weights: asset pricing implications of value-weighted indexing (2020)
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