This white paper first appeared in the Journal of Index Investing (Volume 11 Number 1, Summer 2020).
The Index Effect has weakened significantly since 2011. The Index Effect is the phenomenon where stocks that are added to an index experience positive excess returns in the days before being officially added, while stocks that are removed from an index experience negative excess returns. The weakening of the Index Effect has been pronounced for large- and mid-cap stocks, though it still can be observed in many indexes with small-cap stocks.
The article also examines the importance of several other aspects related to the Index Effect, including illiquidity and unscheduled rebalances. The weakening of the Index Effect has occurred concurrently with a substantial increase in passive investing. One potential explanation for the weakening is that the ETF market makers (e.g., authorized participants) trade on price disparities as soon as they occur, eliminating any sustained positive or negative price movements. If true, this would be evidence that ETF trading adds liquidity to the market.
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