When we talk about the stock market, experts suggest countless strategies to move in the market and offer good returns to their predecessors. Among them there is the strategy called “stock index effect” which consists of buy those companies that will soon be integrated into a large stock index.
The logic behind this is, in the first place, for the public’s own attention. When a company joins a large stock index well positioned in the capital market, investors put it on the radar and searches for the company on Google increase.
The second argument to support this effect is that the company will experience greater institutional and passive ownershipIn other words, the company has more investors who invest in it because it belongs to a large index than because of its fundamental characteristics. This increase in passive ownership could cause the company’s share price to rise.
In the S&P 500 given that it is the most followed index in the world -13.5 trillion dollars were indexed or referenced to the indicator of US large-cap equities at the end of 2021- and, therefore, if the growth of passive investment contributed to an index effect, you’d expect it to show up in the ups and downs of the S&P 500.
Passive investing has grown enormously in the last five decades: cumulative flows in index-linked investment products have exceeded those in active funds since 2008, and the exchange-traded funds (ETF) sector has grown from $ 807 billion at the end of 2007 to almost $ 8 trillion in 2020.
Historically, newly added stocks in the S&P 500 index have been observed to experience an upward price variation during the time that elapses between when the change in the composition of the index is first announced to the public and when the change in the index becomes effective.
One of the most famous examples has been Tesla. On the same day that it was announced that it would be incorporated into the S&P 500, November 16, 2020, its shares rose 8.2%, after two months of lateral movement. This did not end here, in the following 53 days before his incorporation its price increased by 116%.
The literature has shown that this rising price drift results in a positive abnormal return for stocks when they are first added to the S&P 500. This price movement has allowed some investors to take advantage of the positive abnormal returns buying newly added shares on the date of the announcement and selling them on the date of incorporation.
Let’s go to the data. We have different studies carried out in different time areas that conclude that on the day of the announcement of the incorporation of the company to the S & P500, the profitability of that first day is around 4%. If the period until entering the index is analyzed, reported profitability is close to 7%. However, if the 40-60 days after its inclusion are included, the shares slow the advance, in rises of 4-5%.
But studies such as that of the S&P Research department have segmented the behavior of this strategy over time and the index effect of the S&P 500 seems to be in a structural decline, with the average of the excess profitability of our sample of additions falling from 8.32% (1995-1999) to -0.04% (2011-2021). The average magnitude of excess returns associated with stocks falling from the index also decreased, from -9.58% (1995-1999) to 0.06% (2011-2021).
The decline in the effect of the index is likely to be the result of many structural changes taking place in the financial industry and capital markets. The results show, for the first time, that there are currently no abnormal returns between the announcement and onboarding dates, indicating smoother rebalancing mechanisms.
Newly Added Companies Inflate the S&P 500 Index by less than 10 basis points per year. The results could be attributed to improved execution algorithms used by banks, and potentially new regulatory reforms in the sector, which prevent financial institutions from taking on large trading positions with their balance sheets.