Scientific Beta

Factor indices rebalance their positions systematically and transparently at fixed rebalancing dates. We investigate whether the performance of such indices suffers from the response of stock prices to rebalancing trades. Studying a particular set of multi factor indices that have been replicated since 2013, we find that there has been no significant price effect. These findings are in stark contrast to results for cap-weighted indices, for which price reactions have been substantial around reconstitution events. 

Factor indices rebalance their positions systematically and transparently at fixed rebalancing dates. We investigate whether the performance of such indices suffers from the response of stock prices to rebalancing trades. Studying a particular set of multi factor indices that have been replicated since 2013, we find that there has been no significant price effect. These findings are in stark contrast to results for cap-weighted indices, for which price reactions have been substantial around reconstitution events. We argue that the absence of price effects in the factor indices we analyse may be due to several mechanisms. First, unlike inclusion in a major cap-weighted index, inclusion in a mechanically rebalanced factor index is unlikely to provide real advantages to companies included. Second, price pressure is unlikely to be an issue if broad diversification makes it easy for investors to find substitutes for index constituents and if index rules limit trading in less liquid stocks. Third, pre-announcement of weight changes creates competition among liquidity providers, keeping cost for investors low. Our results do not necessarily extend to other factor indices with different construction rules. We argue that index providers should offer information to investors on the price effects generated by their indices.