Indexing and Stock Price Efficiency

Indexing has experienced substantial growth over the last two decades because it is an effective way of holding a diversified portfolio while minimizing trading costs and taxes. In this article, we focus on one negative externality of indexing: the effect on the efficiency of stock prices. Based on a sample of large and liquid US stocks, we find that greater indexing leads to less efficient stock prices, as indicated by stronger post‐earnings‐announcement drift and greater deviations of stock prices from the random walk. We conjecture that reduced incentives for information acquisition and arbitrage induced by indexing and passive trading are probably the main causes for degradation in price efficiency.