Every quarter, the analysts at Standard & Poor’s pull out their market capitalization list and take a moment to rebalance the S&P 500. Since this index is simply a basket of the top 500 U.S. stocks by market cap, that’s a pretty simple process — literally no thought, just additions and deletions based on the size of the company.
If a company has dropped in size and no longer makes the top 500, it gets the boot and is replaced by one that’s grown enough to be included in the list. Pretty simple. But what’s not so simple is figuring out the effect those changes have on the prices of the stocks added and deleted.
It’s long been a theory that, because of the mindless purchases of index funds, addition to an index such as the S&P 500 causes the price of a stock to increase. It makes sense. Simple supply and demand. Fund managers have to keep their portfolios balanced to track the index. So when a stock gets dropped, they sell their shares. When one gets added, they buy it. Increased demand with unchanged supply means prices should go up. It’s simple economics.
And when looking at the performance of new additions to the S&P 500 over the years since index funds gained popularity, we’ll see that a stock gains, on average, about 7% in the week following S&P’s announcement that it’s making the big leagues.
Last week, the most recent rebalance took place. The S&P dropped Diamond Offshore Drilling and replaced it with cosmetics company Coty Inc.
Shares of Coty followed the pattern and popped about 5% in afterhours trading following the announcement and have since continued to rally another 1% or so. That’s great news for those who owned shares before the announcement and even those who were able to get in right after. But is it a sound investment strategy? I mean, does it make sense to buy based on inclusion in an index?
In recent years, the effectiveness of just that strategy has been called into question by several researchers.
Testing the Theory
In a study performed by researchers at Amherst College and the Board of Governors of the Federal Reserve System, the long-term benefits of this strategy were put to the test… and came up short. Short term, that is.
By studying over 300 additions to the S&P 500, the researchers found that, especially for stocks added since index funds really took off, any price increase is reversed within a couple of months. To see this in action, just take a look at the charts of two stocks added to the index this past July:
Both had retraced and lost all of the initial gains before they had been in the index for two full months.
What’s more interesting, though, is the reason the researchers found for the initial price increase.
You see, Standard & Poor’s announces the stocks they’ll be adding to the index about a week before they’re actually put in. And the fund managers don’t add them until after they’re an official part of the index. But the biggest price increase comes in that week between announcement and addition. What that tells us is that the majority of the increase is caused by speculators driving up the share price in anticipation of more increases as fund managers buy in.
But since the managers don’t want to buy stocks at inflated prices, they typically time their orders so that they purchase a large amount of stock through several trades. That way, they don’t change the price too much by submitting one massive order.
So, most of the price increase we’re seeing is people misunderstanding how the market works and driving the price up anyway. It’s become a self-fulfilling prophecy. Because enough people believe that inclusion in an index means an increase in price, inclusion in an index leads to an increase in price — just not a lasting one.
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Short Term, MAYBE. Long Term, NO
According to the research, investing in companies that have been added to an index solely because they’ve been added to an index is an OK short-term strategy. If you act quickly enough, you can capture 5–7% gains from the speculation of other investors. But, as was the case with Coty, by the time most of us heard of the impending addition to the S&P 500, the price had already been bid up 5%. That’s most of the gain from the announcement right there.
If you’re looking for a long-term strategy, this is not it. You’re going to get into the stock when it’s on the way up and then hold onto it while all those gains are erased over the next couple of months. You might even buy after the gains have all been had, and then you just get to watch the stock price fall.
So, if you’re looking for a quick 5% gain, this strategy might work for you. But if you’re looking for bigger gains over the long term, you’re better off sticking with the kind of fundamental research we do here at Wealth Daily and in our investing services like The Wealth Advisory. It’s that kind of research and those strategies that will really grow your nest egg.
To investing with integrity (and a long-term horizon),
Jason Williams
Wealth Daily
Follow me on Twitter @AllBeingsEqual
