Investors can't rely on the "index-effect" for a quick buck: S&P

Joining or leaving a major index once shifted a company's stock price, but new research from S&P shows this so-called "index effect" has faded.

From 1995 to 1999, a company joining the S&P 500 experienced a median excess return of 8.32% between announcement date and the date it joined the index. This was because index-tracking funds are forced to buy or sell the stock to mirror the index. However, between 2011 and 2021, this fell to just -0.04%.

The story is similar for those booted from the index. A stock price reduction of -9.58% between announcement and departure in the late 1990s, to barely any impact (0.06%) in the last decade.

According to S&P, the effect has become “a victim of its own success”. The surge in index tracking funds created a deluge of liquidity that drowned out the effect. In other words, with so many more index funds to act as buyers and sellers now, index changes no longer lead to major price changes.

“Once a company is added to the S&P 500, investors tracking the index typically buy portions of the company to avoid tracking error,” said the report.

“At the same time and for the same reason, investors tracking the mid-cap S&P 400 and the small-cap S&P 600 would be looking to sell their holdings in that same company.”

Assets tracking the large-cap S&P 500 rose almost tenfold between 1996 and 2020, from US$577 billion to US$5.4 trillion. Similarly, for the mid-cap S&P 400 and the small-cap S&P 600, tracking assets rose 12 and 90 times, respectively.

The effect has been in decline since the mid-2000s, according to the report. A separate 2008 study found evidence for its decline outside the US in four other global equity markets—Canada, Japan, the UK and Germany.

The S&P 500 is the world’s most widely tracked index and changes are watched closely by investors. Decisions are made by an Index Committee of S&P employees who meet monthly. Companies must meet criteria for earnings, liquidity and market capitalisation, among other factors.

The report comes amid media speculation that GameStop (GME), the "meme stock" caught up in retail investor's efforts the squeeze hedge funds, could join the S&P 500. After rising 998% this year, it is twice as valuable as some smaller companies on the index. While GameStop meets the index’s liquidity and market capitalisation criteria, it may be held back due to several quarters of negative earnings.

Elsewhere in the report, S&P found that companies that join the S&P 500 see an increase in the dollar value traded due to greater investor attention and analyst coverage. Higher market liquidity can make it easier to buy or sell a stock without changing the price.

The number of companies moving into the S&P 500 fell slightly over time, from 26 annually in the 1990s to 17 a year between 2011 and 2021.

The report studied the S&P 500 between 1995 and June 2021. It compared stock performance between the announcement date and the “effective date”, the last market close prior to inclusion or exclusion in the index. The effective date is when index tracking funds tend to buy or sell.