Research in the latest working paper "Tracking Biased Weights: Asset Pricing Implications of Value-Weighted Indexing" by Hao Jiang (Michigan State University), Dimitri Vayanos (FMG/LSE) and Lu Zheng (University of California, Irvine) has been reported in Wall Street Journal, Fortune magazine and Bloomberg.
The authors study theoretically and empirically how the growth of passive investing impacts stock returns. They show 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 the study's 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.
Further reading:
"The ‘Small-Cap Effect’ Isn’t Dead, After All" by Mark Hulbert, Wall Street Journal, January 2021
"The fundamental flaw in cap-weighted index funds and how investors might take advantage" by Geoff Colvin, Fortune magazine, January 2021
"Index-Fund Trillions Are Distorting Prices in the S&P 500" by Gregor Stuart Hunter, Bloomberg, January 2021
Working paper: Tracking Biased Weights: Asset Pricing Implications of Value-Weighted Indexing by Hao Jiang (Michigan State University), Dimitri Vayanos (FMG/LSE) and Lu Zheng (University of California, Irvine)
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