FEATURE: TRADING
The shrinking
index effect
Trading stocks as they are added to
a particular index has been a
popular trading strategy, but its days
may now be numbered, write
Srikant Dash, CFA, and Aye M Soe
BY: SRIKANT DASH, CFA; AYE M SOE
© ART GLAZER
EXECUTIVE SUMMARY
pop, but instead we wish to highlight an inter-temporal shift in the index
eff ect, which we believe has important ramifi cations. In 2004, we
• The index effect is one of the most researched
published research confi rming anecdotal stories about the decline in the
pricing anomalies in modern fi nance.
index eff ect for S&P 500 additions. Today, we extend the scope of that
• Excess returns for index additions have
research by analysing the index eff ect in a global context by studying the
diminished over the past fi ve years.
price eff ects of index additions for the S&P 500, DAX 30, FTSE 100,
• This may be attributed to several factors,
S&P/TSX 60 and Nikkei 225. Th ese indices are the headline stock
including more arbitrageurs entering the
market indices for fi ve of the biggest equity markets in the world and
market, and changes in market structure and
have large amounts of indexed assets and active derivatives markets
trading patterns of index funds.
linked to them.
• The index effect may never vanish completely, Much of the literature and theories surrounding index eff ects has been
but its days as a profi table trading strategy focused on the S&P 500 deletions and additions, but the other indices
may be numbered. have also been the subject of a fair amount of research.
Most studies attribute the index eff ect to one of fi ve competing
hypotheses. According to the price pressure hypothesis, prices will reverse
after the index change when heavy index fund trading subsides around the
F
rom tests of demand curves of change date. According to the imperfect substitutes hypothesis, the price
stocks to more recent industry eff ect is permanent because index fund buying changes the available fl oat
research on ‘wealth loss’ of shares. Th e liquidity hypothesis suggests that prices are aff ected if the
associated with changes to liquidity of stocks being deleted is aff ected. According to the information
popular stock indices, the price pop of a content hypothesis, index addition and deletions have information on fi rm
stock added to a headline index, or the specifi c factors that will aff ect prices of the fi rm’s stock. Also, additions and
‘index eff ect’, has been a much deletions from the index aff ect the level of scrutiny and analyst coverage of
researched topic. the stocks. According to the selection criteria hypothesis, evidence of
Th e fact that stocks added to a popular abnormal returns is not robust since the stock selection process followed by
index experience excess returns and index providers itself uses historical prices.
volumes between the announcement date Declining excess returns have led to research on alternative ways to
(AD) and eff ective date (ED), followed by profi t from index changes, such as replicable options-based trading
a small post-ED correction, has been well strategies that seek to capture the index eff ects. A study in 2008 found
documented over the past two decades. that buying at-the-money calls for S&P 500 additions from outside the
Our aim here is not to revisit the S&P 1500 on the day after the announcement and selling the position
usual pattern of the post-addition price on the eff ective date yields returns of 32% on average.
WWW.CFAUK.ORG PROFESSIONAL INVESTOR 29
29-3129-31 Shrinking indices.indd 29Shrinking indices.indd 29 1/6/091/6/09 11:52:2811:52:28Professional Investor Summer 09.31 31 4/6/09 15:40:57
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