Bridge over ocean
19 December 2019 CFA Institute Journal Review

Indexing and Stock Market Serial Dependence around the World

  1. Imrith Ramtohul, CFA

This is a summary of "Indexing and Stock Market Serial Dependence around the World" by Guido Baltussen, Sjoerd van Bekkum, and Zhi Da, published in the Journal of Financial Economics.

Recent years have seen a remarkable change in index return serial dependence across stock market indices in developed markets. Largely because of the impact of indexing, such dependence has shifted from positive to negative. Although index-type products remain popular, they can have a negative result: excessive price movements on returns. Proactive investors can, however, enhance returns through opportunistic liquidity provision.

What Is the Investment Issue?

Many studies have demonstrated a positive serial dependence in stock index returns. The authors provide evidence that the serial dependence in index returns has actually turned significantly negative across 20 major market indices in developed markets. Negative serial dependence indicates index return reversals that are larger and more frequent and that cannot be directly explained by traditional explanations.

How Did the Authors Conduct This Research?

The authors collect data for biggest, busiest, and most significant stock indices in developed markets around the world, as well as for their corresponding futures and exchange-traded funds (ETFs). They consider 20 stock market indices covering markets across North America, Europe, and Asia Pacific. To avoid double counting, the authors exclude such indices as the DJIA because all of its listings are also in the S&P 500 Index. The sample period runs from each equity index’s start date to 31 December 2016, or when all futures on the index have stopped trading. The authors use Bloomberg data to obtain market information on equity indices, equity futures, and ETFs.

They measure serial dependence using conventional measures and introduce a novel statistic to capture serial dependence over multiple lags.

What Are the Findings and Implications for Investors and Investment Professionals?

The dramatic change in serial dependence is significantly related to indexing (i.e., the growing popularity of index products such as equity index futures, ETFs, and mutual funds). Around the world, index serial dependence tends to be positive before the introduction of index products, in line with previous studies, but decreases once index products are introduced on the index and eventually turns significantly negative as indexing gains importance.

The authors find that introducing indexing has a negative correlation with index serial dependence. As an index’s exposure to index-type products rises by 1%, the serial dependence falls by –0.031. Serial dependence being negative for both the index product and the index points toward arbitrage between the two markets. A strategy that trades against negative serial dependence could enhance the Sharpe ratio. However, the strategy will also require frequent rebalancing and may not be profitable after transaction costs.

Evidence also exists that index arbitrage tends to spread negative serial dependence between index products and the underlying index. Excessive price movements could occur even at the index level. However, proactive investors could still improve return from opportunistic liquidity provision.

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