Why the Index Effect Is Now Ineffectual
Art by Isabella Fassler
For sharpie investors, there used to be a slam-dunk way to make an investing profit: When an index like the S&P 500 or the Russell 1000 announced a rebalancing of its portfolio, the added stock rose in price and the one it replaced dropped. This is known as the index effect, and speculators loved to take advantage of it.
But lately, the index effect is much diminished, thanks to a host of market changes, mainly the rise of exchange-traded funds (ETFs), the vast bulk of which track indexes. That, plus the increase in high-frequency trading and low volatility due to a long period of stable economic growth, has made these trades very crowded. Result: Big prices moves in affected stocks don’t occur as much anymore.
Obviously, getting selected for index membership is a boon to a stock’s price because the index funds that mirror the likes of the S&P 500 need to buy it. And the reverse is true for a stock that get booted out. A defenestration takes place when a stock no longer meets index criteria, such as maintaining a certain market cap level. In the S&P 500’s case, that’s $5.3 billion.
What makes pre-rebalancing trades possible is that an index announces a change several days before adopting it. (The delay gives a fund manager time to orchestrate an orderly transition.) When the S&P 500 tapped Fluor, the engineering and construction company, it revealed the addition on May 28 and then listed the shares a week later, on June 4.
Back when the index effect was more pronounced, arbitrageurs often bought an added stock at the inclusion announcement and sold it right before or at the effective date, pocketing the price run-up. For a deletion, they could short the stock (a bet on its decline) at announcement and cover later, after the price sank.
The turning point, when the index effect shriveled markedly, was 2013, according to a recent study from Axioma, the analytics provider. The firm tracked prices on additions and deletions from the S&P 500 from 1989 to the end of 2012, and then from 2013 through last August. “By 2013, ETFs had expanded and made the index effect disappear,” said Tony Renshaw, director of applied research at Axioma.
The Exit of the Arbs
The arbitrageurs, who once benefited handsomely from the index changes, had the best returns when not a lot of other investors were involved. With legions of ETFs jamming into the trade, the arbs’ rebalancing exercise became a less happy hunting ground. “The arbs have gone away,” noted Peter Borish, chief strategist at the Quad Group. “So the spread narrows over time”—meaning the gap between the price when an index names a stock for addition or removal to the index and the price at which the index fund buys or sells it later.
Prior to 2013, the Axioma study shows, added stocks grew steadily in price right up to the date when the index rebalances its holdings and the funds actually bought the new arrivals. After the announcement, an added stock gained as much as 1% in excess return (above what the overall index had done) right before the index fund buying. After the index funds made their purchases, the price most often dipped back to near where it had been.
The impact on deleted stocks was the reverse. The dropouts slid by an up to 1.5% before the index funds officially dumped them. Once they were out of the index, they too tended to return to their previous levels.
Since 2013, the absence of the speculators has made a vast difference. “More people were in the trade in the 1990s and early 2000s,” said Lance McGray, head of ETF product at Advisors Asset Management. “Now, that’s not as much of a concern.” Nowadays, price changes are minimal, and cluster around what they were before the indexes announced a shuffle.
Generally, the fall of the index effect has been salutary for buy-and-hold investors because index funds don’t have to pay premium prices for added stocks, which the speculators have bid up. “Tracking error now is de minimis,” Borish said, referring to the difference in returns between an index fund and its underlying index.
Say the S&P 500 gained 5% for the year, but a fund following it turned in a 4.7% performance because it had to pay arb-inflated prices for stocks added to the index. The tracking error is 0.3 percentage point, and thus index fund investors don’t realize all of the gain.
The ETFs Become a Force
Indeed, ETFs have enjoyed an enormous expansion since the 2008-09 financial crisis. Before the cataclysm, these vehicles—which are traded throughout the day like stocks, and mainly have passive portfolios that mimic indexes—held just south of $700 billion in assets worldwide, research firm ETFGI says. Today, they have swelled to more than $5 trillion.
The crisis created fertile ground for ETFs to thrive. In 2008, banks unloaded their stocks to strengthen wobbly balance sheets, and a lot of inventory was suddenly available for ETF issuers to snap up. The demand for diversification became intense among retail investors, who had been burned holding actively managed mutual funds and individual stocks. ETFs had an easy time convincing the frazzled investors to jump aboard. Nowadays, passive investing continues to be all the rage.
The mechanics of ETF construction are integral to the shrinking of the index effect, now that the arbs have retreated. The underlying stocks that make up ETF index portfolios are provided by authorized participants—financial institutions that create and redeem ETF shares. As an index change is announced, hordes of these agents trade in the affected stocks.
But their motive, unlike those of the arbs, is not to make a quick buck and depart the scene. They earn a reliable profit exchanging the stocks for ETF shares, and that produces a steadying influence on price changes in toto.
A glimpse at a couple of additions this year shows how muted the index effect has become. The US Index Committee for the S&P 500 announced June 25 after the market close that Market Axess, a financial data company would join the index. From then until the stock actually was included in the index on July 1, the price rose around $3.54, or 1.1%.
Yet then we have to factor in how the index itself did, which this year—other than May’s downdraft and last week’s step down—has been energetically upward. The S&P 500 increased 1.78% during Market Axess’ announcement-to-buy-date period. Hence its excess return (the stock’s increase subtracting the index’s) was -0.68%.
The return was a little better for Teleflex, a health care equipment maker. From the announcement on Jan. 16 to the buy date, it climbed 3.73%. Meanwhile, the S&P 500 advanced 2.08%. Upshot: Teleflex’s excess return was 1.65%.
The Indexes’ Rebalancing Act
Over time, indexes rejigger their portfolios to best reflect the stock market, or at least the portion of it they cover. For the S&P 500, in addition to maintaining a minimum $5.3 billion market valuation, a constituent company must meet a number of conditions such as having a US headquarters, half its shares in public hands, and four straight quarters of positive earnings.
Should a member company, no matter how iconic, fail to meet these qualifications, then bye-bye. In the 1920s, US Steel was part of the original S&P Composite, the forebear of the 500, of which it was a stalwart member for decades. At one stage, the steelmaker boasted the world’s highest market value. By 2014, though, it had dwindled in sales and market cap. Martin Marietta Materials, a provider of sand and gravel for construction, took US Steel’s place.
Companies fall off the list for other reasons, as well, like bankruptcy, reorganization, and mergers and acquisitions. When software company Red Hat got bought by IBM, it was no longer eligible for the S&P 500, which it had joined in 2009. Wireless carrier T-Mobile substituted for Red Hat.
The frequency of rebalancing varies. The S&P 500, which covers large-cap companies and comprises some 70% of the US stock market, makes changes throughout the year on no set schedule. Parent S&P Dow Jones Indices—owned by S&P Global, CME Global, and News Corp.— has its index committee meet as often as monthly to assess the markets fluctuations and how to embody them in the portfolio.
Also tracking large American stocks, the Russell 1000, which the London Stock Exchange bought five years ago, does an annual rebalancing every June. The FTSE 100, owned as well by the London bourse, is the benchmark for the most sizeable British stocks.
MSCI, formerly a Morgan Stanley unit and now an independent entity, has its flagship EAFE index for large- and mid-cap companies in developed nations (except for the US and Canada). It rebalances twice a year. All these index issuers have myriad other indexes for smaller stocks and those in an array of categories.
What changes will be made is not very hard to figure out, which is another reason that the index effect has wasted away with so many more players involved. Certainly, how S&P, Russell, and the other index outfits rebalance is not a mystery. Russell in particular is very clear on what its criteria are. “People can easily model how they do it,” Axioma’s Renshaw said.
With a scarcity of price differentials to act upon, the speculators have one fewer arena to play in. And index investors have less tracking error. Not a bad trade.
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