Index Fever

Updated: Feb 12, 2021

Does the addition of a company to an index really matter? Should investors buy companies which are being added to popular indexes?

Whilst everything seems more flamboyant in market activity in the US compared to the UK, there is a phenomenon that plays out in markets across all geographies. Tesla, the $650bn electric automaker, has just been accepted into the S&P500. Even after a spectacular 700% gain in 2020, notice that the stock will be included in the world’s premier index has driven the stock 30% higher post the announcement and entry. Several market commentators will tell you this is a justified leg up because index funds — passive ETFs that track the likes of the S&P500 — will be forced into buying Tesla, resulting in the stock price pushing even higher. This theory leads to a wave of speculative buying from institutions and retail investors alike (I’m not sure there is much difference between the two at the moment!) further pushing the stock to new heights.

In so far as its spectacular performance this year, Tesla has been a market anomaly. However, this article will aim to address whether inclusion in popular indexes actually drives long term gains for stock and shareholders and whether it should be used as a short term trading strategy. We also must consider that companies are occasionally removed from indexes for various reasons - if we should buy based on inclusion, should we sell based on exclusion?

To review this in more detail, I have done a deep dive into historic inclusions into indexes and analysed cases where possible performance post-announcement contrasted to performance post-first-day-trading in the new index. Whilst this dataset represents a varied set of industries and indexes, it is by no means conclusive and more work would need to be done to firm up any kind of statistical inference.

I have put together a sheet of 26 recent inclusions into the S&P500 index (of which you can see 20 above). The table shows the gains made post-announcement of index inclusion, and then the gains made when the stock was actually included in the index (this often doesn't happen right away. In order to give tracker funds enough time to make purchases, a one month period post inclusion in the index should suffice).

On an individual basis, the table makes for interesting reading. Some stocks — such as Teladyne — popped 14% on the news of S&P500 inclusion, only to pare those gains by 8% once they were actually included in the index, dropping them to 6%. In aggregate, gains for the basket averaged 3.71% post-announcement and 2.37% post-inclusion, giving a total gain for the stock specific periods of 6.08%. Compare this with the average S&P500 gain of 2.81% in reflective periods, to which the above stocks have been measured, and you have a compelling argument for buying the stock after the news of its inclusion into this index. However, this basket of stocks were driven on average 3.71% higher before even trading in the index, compared to a more muted average gain of 2.37% when inclusion occurs. I would be inclined to say that gains that occur over the period are more likely to be speculative buying at the thought of inclusion, than driven by index tracker purchasing activity themselves. This is an important discernment to make as I would expect any strategy of buying stocks on the premise of speculative gains to suffer in periods of time that markets are not as buoyant as they are in current times.

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