Article | Review of Financial Studies | April 2008

Excess Comovement of Stock Returns: Evidence from Cross-sectional Variation in Nikkei 225 Weights

by Robin Greenwood

Abstract

In the presence of limits to arbitrage, cross-sectional variation in periodic investor demand should be related to the degree of comovement of returns. I exploit the unusual weighting system of the Nikkei 225 index in Japan to identify cross-sectional variation in periodic demand for index stocks. Relative to their weights in a value weighted index, some stocks in the Nikkei are overweighted by a factor of ten or more. Using overweighting as an instrument for the proportionality between demand shocks for index stocks, I find a strong positive relation between overweighting and the comovement of a stock with other stocks in the index, and a negative relationship between index overweighting and comovement with stocks outside of the index. Put simply, overweighted stocks have high betas. The results suggest that excess comovement of stock returns is a consequence of an institutionalized commonality in trading behavior, rather than inefficiencies related to the speed at which index stocks incorporate economy-wide information.

Keywords: Stocks; Investment; Investment Return; Market Transactions; Weight; Performance Expectations; Behavior; Japan;

Citation:

Greenwood, Robin. "Excess Comovement of Stock Returns: Evidence from Cross-sectional Variation in Nikkei 225 Weights." Review of Financial Studies 21, no. 2 (April 2008): 1153–1186.