The S&P500 index effect reconsidered: Evidence from overnight and intraday stock price performance and volume

Abstract

This study focuses on S&P500 inclusions and deletions, examining the impact of potential overnight price adjustment after the announcement of an S&P500 index change. We find evidence of a significant overnight price change that diminishes the returns available to speculators although there are still profits available from the first day after announcement until a few days after the actual event. More importantly, observing the tick-by-tick stock price performance and volume effects on the key days during the event window for the first time, we find evidence of consistent trading patterns during trading hours. A separate analysis of NASDAQ and NYSE listed stocks allows for a detailed examination of the price and volume effect at an intra-day level. We find that index funds appear to cluster their rebalancing activities near to and after the close on the event date, suggesting that they are more concerned with tracking error than profit.

Introduction

Over the last 20 years, index funds have become extremely popular, with total worldwide explicitly indexed assets estimated to exceed $1 trillion. When “trackers” follow a benchmark index, their investment decisions are not based on fundamental analysis. Instead, they make the necessary portfolio adjustments only to reduce tracking error, which ensures that such funds will prefer index member stocks to non-members. Thus the deletion of an existing member-firm from a widely followed benchmark has a significant implication for fund managers. For pure index trackers, the only reason, apart from changing cash flows, for trading stocks will be index composition reviews.

The “index effect” refers to the price pressure that is observed when a stock is added to or deleted from an index. If the index is widely tracked, then profits can be made by buying (selling) the shares of the added (deleted) firm ahead of index funds and selling (buying) them at a later stage, when index fund demand (supply) is satisfied. The more money is tied to the index, the more index portfolio managers will be involved in trading the underlying stocks around index recomposition. Index trackers ensure that demand will increase for added stocks and will reduce for deleted stocks. For many years, “buying additions and selling deletions” has been a lucrative strategy for investors not involved in index tracking.¹

This study examines the impact of potential overnight price adjustment after the announcement of an S&P500 index addition as well as the impact on the prices and volumes of the stocks on a tick-by-tick basis. A separate analysis is conducted for additions and deletions and also for NASDAQ listed versus NYSE listed stocks. Previous studies have mainly concentrated on close-to-close abnormal returns and showed that there is a significant price increase between the close on the announcement day and the close on the day after. However, the purchase of the added stock cannot be made at the close of trading on the announcement day because the information is released to the market after the close. The first trading opportunity arises in the morning of the first day after announcement, when the stock usually opens at a considerable price increase, resulting in lower actual trading profits; our study investigates this issue in detail.

The following analysis differs from previous studies in four important areas. First, the results involve not only close-to-close abnormal returns but also overnight and open-to-close returns. Second, the tick-by-tick stock price performances and trading volumes of the added stocks are examined for the first time for the years 1999 and 2000. This analysis enables us to provide a more detailed picture of the objectives and actions of index fund managers and arbitrageurs. Third, NYSE and NASDAQ samples are examined separately to determine the impact of trading venue on the index effect.² Finally, we make use of a more recent and longer run of data on index additions than was available in previous studies.

The remainder of this study is organized as follows. Section two provides a brief description of the major stock selection criteria and the announcement policies of the Standard and Poor’s Index Committee. Section three presents a brief summary of previous relevant studies associated with S&P500 index changes and the prevailing hypotheses that lie behind the companies’ post-event performance. Section four examines the stock performance after addition by using overnight and open-to close data and section five provides results using tick-by-tick abnormal returns. Section six presents an analysis of the index effect at the intra-day level and section seven examines the intra-day index effect of a deletions sample. Section eight concludes.