The Index Effect
Stock Price Behaviors for Index Inclusion and Exclusion are Subtle
Ch-ch-changes, just gonna have to be a different man
Time may change me
But I can't trace time
Source: Changes, David Bowie.
Introduction
Originally I had planned an article on value investing as the first of this new category (which will come soon I think). But following the comments
’s new article on Diversified Energy DEC 0.00%↑ and the looming FTSE 250 exclusion I remembered a piece of research that makes for an easy kick-off to this new section. (The planned article value investing is more convoluted.)Feedback is very welcome.
The Index Effect…
Traditionally, the “Index Effect” was the observation that as stocks were added to an index such as the S&P 500, they saw significant positive price effects, while deleted stocks saw negative effects. One possible explanation for this behavior was funds tracking the index would be forced buyers and sellers. Another reason I could buy into would be increased “advertising” of the stock or a perceived “seal of quality” to retail investors for included stocks in prestigious indices.
In recent history, however, it was reported that the traditional Index Effect seemed to be weaker or even disappearing. I believe one of the reasons is that index changes are communicated and funds start rebalancing in a window around the actual change date - or rather on the day of announcement and prior to the rebalancing1.
…is More Subtle Than That
This is a learning article, so why bother with this widely-known effect?
I remembered seeing research (and found e.g. this research from IHS Markit) that shows that being demoted from S&P 400 to S&P 600 is positive for the stock price. The reason seems to be that an S&P 400 stock about to be demoted is presumably at the lower end of index weighting from a market capitalization perspective. Consequently, funds that use market weighting will have relatively small exposure anyway. As the stock enters into the S&P 600 it is a bigger fish, relatively speaking. Thus indices tracking the smaller index will weigh it bigger. I speculate that the mechanism depends also on the size of the AUM of the funds in question, but in the words of IHS Markit:
One of the biggest surprises from our analysis was the trading impact of being “demoted” to the S&P 600 from the S&P 400. In this case, companies gained an average of 6.2% on the trading day of the announcement. This is counterintuitive because one would suspect that a stock would decline when it was demoted to a smaller index. However, when we analyzed companies’ funds, we found that small cap index funds hold a larger percentage of shares outstanding than mid cap index funds. The result of this is a net inflow of index shares resulting in buying pressure. Summarized in an analogy, “would you rather be a big fish in a small pond or a small fish in a big pond?”
Is the Index Effect Dead?
I guess not - but it is more subtle.
It seems to have moved towards the date of announcement (see footnote 1)
If a stock “moves up” to a bigger index or “down” seemingly has counterintuitive effects due to the relative weighing in those indices. But I assume that the Assets Under Management of index tracking funds play a role, too.
The “Traditional Index Effect” appears to be still true for stocks that get added to an index if they were not in any of the other indexes before that index change; a removal from the small-cap index is bad.
Trading Volumes behave as you would expect after reading this short article:
Typically, on the date of an S&P index change announcement, volume will be 200-500% of average volume. On the date the issuer moves out of or into the index, volume tends to be 150-250% of average volume.
The findings from IHS Markit from 2020 do make sense to me. Will this behavior be similar for other indices than the S&P 500, S&P 400, and S&P 600? Will the FTSE indices or the German indices behave correspondingly? I would think so, and it forms my working assumption - although I do not trade around such things typically when it coincides with my fundamental analysis, why not leverage it? I assume that related studies on other international indices have been conducted already and I am simply unaware of them.
Will trading strategies arbitrage away the effects? Who knows.
According to the referenced IHS Markit paper: “As would be expected in an efficient market, all of the price abnormality typically occurred on the date of the announcement, as market participants anticipate the future impact of fund rebalancing. No statistically significant trend could be found on the date of the fund moves, date of index inclusion, or over the next few months.”