How Much Indexing Is Too Much

Does the global rise of equity indexed products such as futures and ETFs improve price efficiency in the underlying index? We study the impact of such “indexing” on serial dependence in 21 major market indices covering 15 countries across North-America, Europe, and Asia. Using a novel trading-strategy-based methodology, we find that average profits on a trading strategy based on index autocovariance switch from significantly positive (0.07) to significantly negative (-0.04) after the introduction of the index futures contract. Trading profits on autocovariance in the very liquid index futures markets are also negative and significant (-0.05),exceed trading costs, and become more negative as the index exposure to futures and ETFtrading increases. Decomposing S&P 500 index autocovariance into portfolios based on size, volume, turnover, institutional ownership, and analyst coverage, we find that both autocovariances and cross-autocovariances switch from positive to negative, in tandem with the index-level autocovariance. Furthermore, taking advantage of the unusual weighting scheme in the Nikkei 225 index, we find stocks that are overweighted by the index to suffer more negative autocovariances after the futures introduction. Finally, we find that futures more strongly propagate non-fundamental shocks to the index when arbitrage is “easy”. All this suggest that too much indexing has undesirable demand-driven effects, as the arbitrage between the index products and the underlying index may lead to price overshot and reversal and, hence, decreased price efficiency.

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