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The rules for including a stock in indices such as S&P 500 are common knowledge, so everyone can know when e.g. company B is going to enter the index instead of company A. Since ETFs and mutual funds tracking the index have to buy shares of B and sell shares of A, this can potentially used by speculators who would try to quickly buy B and sell it to the ETFs in a high price, while buying A in a low price from the ETFs. Does such kind of speculation have any effect on the stock prices?

Specifically: Suppose someone invents a new index, X&Y 500, in which the identity of the companies is kept secret and revealed only to issuers of ETFs and mutual funds. All other things being equal (e.g. the companies in both indices are equally strong, have the same business potential, the volume of ETFs of both indices is the same, etc.), will the secret index X&Y 500 perform better than the revealed index S&P 500?

EDIT: To make the question even more focused, assume that there is no way to know in advance which stocks are going to enter/exit S&P 500 (e.g. these stocks are selected at random). So the difference between S&P 500 and X&Y 500 is that the stocks in the former are revealed to all traders at the same time, while the stocks in the latter are revealed only to ETF issuers.

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If you believe the efficient market hypothesis, then the answer is no;

At the moment relevant information (say, which allow the company to be added to the index reveal, the stock price would automatically reflect the price as if it was already added to the index, as otherwise there would be arbitrage closable by buying the stock at this moment and selling it when the ETFs are getting in.

In practice, I've tried it a few times myself but it seems that in general the market already takes future ETF investments into pricing quite well.

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  • $\begingroup$ "as otherwise there would be arbitrage " - and maybe there is indeed an arbitrage which is closed quickly, e.g. by algo-trading bots? I am not saying that laymen can make any profit out of it; it is difficult to compete with bots. I am just saying that the ETFs may lose. $\endgroup$
    – Erel Segal-Halevi
    Commented Jan 4, 2015 at 8:52
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A key assumption in your question is that the list of stocks making up your "X&Y 500" could be kept secret. In practice lots of people would have to know, and it's difficult to see how the secret could be kept indefinitely. Assuming that being included in the index gave a company prestige and tended to push the price up, those in the know sooner would have an advantage: they could buy this stock early on at a discount, and then as the word spreads the price would go up and they could cash in.

Maybe that's irrelevant as you're speaking of a hypothetical scenario, and so whether it is practical or not is not the issue.

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  • $\begingroup$ I wanted to isolate the effect of information. So I presented a theoretical question in which the list is indeed kept secret. $\endgroup$
    – Erel Segal-Halevi
    Commented Jan 4, 2015 at 8:54

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