Index Fund Investors Easily Exploited?

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1. Date: 2008-12-02 01:02:47
Subject: Index Fund Investors Easily Exploited?
From: norak <k...@g...com> Search message by this author

Index fund investors buy shares in companies according to an economic
index. Many economic indexes these investors use are represent large
companies, but many also invest in small companies, e.g. tracking the
S&P SmallCap 600 or the S&P Small Ordinaries.

There are many index investors. Index investors believe the market is
efficient and that the price of any asset at any given time is the
asset's true value. Couldn't this be exploited?

For example, a group of people can borrow money, start up a company
that does nothing, buy stock themselves with the money they borrow
until the price of the company's shares goes up to the level that is
required for it to be listed in an economic index. Once this company
is classified within a common economic index, index fund managers will
buy the shares, causing a spike in the share price. After this the
insiders sell their shares, pay back the debt, and profit.

This is a version of pump-and-dump but since index investors simply
buy whatever is in an economic index, there is no manipulation
involved. All that is required is that the company is put into this
index.

Does this sort of thing happen? Should index investors be worried?