Company stocks used to experience large swings as prominent indexers switched up their benchmark holdings, but with the advent of exchange traded funds, these company share price distortions from the so-called index effect have diminished.
According to Axioma research, the rising popularity of ETFs have helped dampen the “index effect” where stock prices are affected by traders buying and selling them ahead of formal changes from index providers, reports Jennifer Thompson for the Financial Times.
Traders have historically pushed up the price of stocks expected to be included in an index, buying the company shares in anticipation of profiting from sales to passive investors whom are forced to gain exposure to the companies once they join the index.
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Index providers would call out new constituents and name dropouts in advance.
Axioma’s study discovered that gains made by trading in advance have declined sharply over the past decade, which has made it less profitable to trade in advance of indexing changes.
“The classic index effect, where additions or deletions have positive or negative returns immediately before rebalance, has declined in magnitude in all markets tested,” Anthony Renshaw, director of index solutions at Axioma, told the Financial Times.
Renshaw attributed the dampened effects to the rise of passive investing and the increased role of authorized participants whom help keep ETFs running smoothly.
Authorized participants, or APs, create and redeem ETF shares. They would buy stocks that are expected to fall out of an index as they can make a profit by exchanging them for a ETF shares, which in turn would support the share prices and reduce the index effect.
Renshaw also argued that the declining index effect has contributed to ETFs being even cheaper than originally supposed for investors.
“It means a buy-and-hold investor in an ETF is having even less costs,” Renshaw said.
Furthermore, the increased reliance on electronic and high-frequency trading, along with low market volatility over the recent years, have contributed to the diminished index effect since 2008.
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