DP15563 Tracking Biased Weights: Asset Pricing Implications of Value-Weighted Indexing

Author(s):	Hao Jiang, Dimitri Vayanos, Lu Zheng
Publication Date:	December 2020
Keyword(s):	Indexing, Limits of arbitrage, Market Efficiency, Mutual funds
JEL(s):	G10, G11, G12, G23
Programme Areas:	Financial Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=15563

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.