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

Author(s): Hao Jiang, Dimitri Vayanos and Lu Zheng

Publication Date: December 2020

Keyword(s): Indexing, Limits of arbitrage, Market Efficiency and Mutual funds

Programme Area(s): Financial Economics

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.

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Bibliographic Reference

Jiang, H, Vayanos, D and Zheng, L. 2020. 'Tracking Biased Weights: Asset Pricing Implications of Value-Weighted Indexing'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=15563