Index tracking and beta arbitrage effects in comovement

This paper develops a stylised model for S&P 500 index changes with two beta-based styles: index trackers and beta arbitrageurs who trade in both high and low beta event stocks to exploit mean reversion towards one. Arbitrageurs engage in common or contrarian trading patterns relative to index funds depending on whether historical betas are below or above one. Thus, the overall comovement effect has two distinct components. After index additions, pre-event low beta stocks drive the overall beta increases due to common demand – albeit for different reasons - from indexers and arbitrageurs. By contrast, arbitrageur shorting of high beta additions diminishes or sometimes reverses the beta increases for these stocks driven by indexers. Analogous results hold for index deletions.