The impact of ETF index inclusion on stock prices

A growing body of evidence suggests that assets included in market indexes such as the S&P 500 trade at a premium relative to other assets. In this paper we look for evidence of such an index inclusion premium in a carefully controlled laboratory experiment. Our environment involves three assets and an Exchange Traded Fund (ETF) index asset. We model Authorized Participants (APs) as bots that create and redeem ETF shares by scanning the order books of the underlying assets. In one treatment, all three assets are included in the ETF index asset. In a second treatment, one of the three assets is excluded from the ETF index and is replaced by a second unit of one of the included assets; the included and excluded assets have identical fundamental values enabling a clean test of whether or not there exists an index inclusion premium. We consider a further variant of the excluded asset treatment where short-selling is allowed. We find that: (i) inclusion of an asset in the ETF index results in a substantial index premium, (ii) this result is tied to an order imbalance which arises when an identical asset is excluded from the index, and (iii) the premium and order imbalance persist even if short-selling is allowed