Trading Patterns and Excess Comovement of Stock Returns

In April 2000, 30 stocks were replaced in the Nikkei 225 Index. The unusually broad index redefinition allowed for a study of the effects of index-linked trading on the excess comovement of stock returns. A large increase occurred in the correlation of trading volume of stocks added to the index with the volume of stocks that remained in the index, and opposite results occurred for the deletions. Daily index return betas of the additions rose by an average of 0.45; index return betas of the deleted stocks fell by an average of 0.63. Theoretical predictions for changes in autocorrelations and cross-serial correlations of returns of index additions and deletions were confirmed. The results are consistent with the idea that trading patterns are associated with short-run excess comovement of stock returns.There is abundant evidence that security prices can move together either too little or too much to be justified by fundamentals. What could be causing this comovement if not fundamentals? Empirical studies have uncovered a variety of common factors in returns, such as size, value, and industry factors. In academic literature, debate is ongoing as to whether these factors are related to fundamental risk or, alternatively, reflect mispricing driven by investor demand. Providers of commercial risk models have stayed away from this debate and include a broad set of factors to explain common variation in asset returns.We argue that one driver of comovement of returns is commonality in trading activity. We tested this hypothesis by using an unusual index redefinition of the Nikkei 225 Index in April 2000 in which 30 stocks were replaced. Upon inclusion in an index, a stock becomes exposed to the trading shocks experienced by other stocks in the index. Whenever index funds experience inflows or outflows, they trade index stocks as a basket. Also, index arbitrageurs delta-hedge their index derivative positions, which requires simultaneous trading in the basket of the underlying securities. Consistent with these observations, we documented a large and significant increase in the correlation of trading volume of the 30 stocks added to the Nikkei 225 with the trading volume of stocks that remained in the index, and we found the opposite results for the deleted companies.We investigated whether the change in trading activity has consequences for returns. We found that after the Nikkei redefinition, the daily return betas of the additions with respect to the stocks that remained in the index rose by an average of 0.45 but the daily index return betas of the deletions fell by an average of 0.63. Thus, index membership alone explained a surprising amount of the comovement among stock returns.We also made predictions about changes in autocorrelations and cross-serial correlations for added and deleted stocks following index redefinition. These predictions, which are not featured in existing research, were motivated by the idea that pricing effects from shocks to correlated investor demand should eventually subside. That is, although security returns of index stocks should comove excessively in the short run, at longer horizons, returns should revert to reflect fundamentals. We found strong support for these predictions. A particularly interesting result is that following index redefinition, daily return autocorrelations of additions decreased whereas return autocorrelations of deletions increased, which suggests that additions (deletions) become more (less) exposed to transitory index-trading shocks. Taken together, our results suggest that commonality in trading baskets induces significant excess comovement of stock returns.Our findings have important implications for modeling risk in equity markets. Index membership is likely to be an important common factor even after accounting for industries and fundamental factors. This aspect is especially important in risk models geared toward daily returns—in that the effects of correlated index trading tend to subside as the return horizon increases. Our results also imply that short-term shocks to index demand add to the transaction costs of index investing.