Many stock indices are based on market capitalization. This means that such indices contain the biggest companies of a certain category. If you invest in such an index you are likely to buy the more expensive stocks. In fact stocks often join such indices after some solid share price gains. These share price gains increase their market capitalization which makes them candidates for indices based on market capitalization.

This effect is significant: economic investigator Rob Arnott has found that indices that are not based on market capitalization perform about 2% better than indices based on market capitalization. For this reason he argues that is it better to invest in indices based on fundamentals, such as P/E, price/sales etc.

Especially large-cap indices may suffer from index arbitrage. Index funds track a certain index, which means that they only invest in stocks listed in their index. Mutual funds often track a certain index as well, which gives them less flexibility to invest in shares outside their index. Since there are many index funds and mutual funds you could buy a stock just before it is announced that the stock is listed on the index. It can be time consuming and computationally intensive to predict these announcements but it is possible and it happens. After the announcement many mutual funds buy the stock since they have to outperform the index. At the day the stock is actually part of the index, the index funds buy the stock making its price even higher. For the S&P500 researchers Chen, Noronha, and Singal have found that the effect of the announcement accounts for 5% price gain and there is another 8% price gain between the day of the announcement and the actual listing in the index.

Predicting when a stock will be delisted from an index can be beneficial as well. Between the announcement and the delisting the share price of a S&P500 stock goes about 8% down on average. Index funds usually posses such shares untill the day they are actually delisted.

My bet is that mid-cap and small-cap index funds do not suffer from this index arbitrage effect.  A mid-cap index fund, for example, gets extra gains for stocks that move to a large-cap index. On the other hand a mid-cap index fund buys potentially overvalued stocks of companies that just made it to its mid-cap index. Probably the first effect more than compensates the second effect. So if you want to invest in small-cap and mid-cap indices it is probably better to choose an ETF with weightings based on market capitalization.

Index funds that use fundamental weighting of their assets usually have a higher expense ratio than index funds based on market capitalization. Again this can be a reason for investing in an ETF with a weighting based on market-cap, especially if it is a small-cap or a mid-cap ETF.