How and WHY does inclusion in an index affect stock prices

It is well known that when a stock gets added to an index, the stock price jumps. This has been known for at least as long as the mid 1980s (Harris and Gurel 1986 JF). However the "why" has been the question ever since.

Some alternative hypotheses that have been examined include

1. "Certification" by the company running the index (for instance, for the Standard and Poors 500, Standard and Poors MIGHT pick stocks that are expected to go up in the future--although S&P do not claim to do so).
2. Increased liquidity
3. Reduced information costs and/or better monitoring (since more analysts may follow the stock)
4. Some investors must be made aware of the stock (Merton's Shadow Cost idea)

After the initial stock price jump was found, further research has shown that the price appreciation on inclusion is greater (and more permanent) than the price decline when the price falls. Which is consistent with the shadow cost hypotheses but still leaves the question of certification in play.

Now Jay Dayha in his paper "Playing Footsy with the FTSE 100 index" offers further insights by studying the FTSE. The fact that the FTSE is used is what really separates this paper.

Why? Becasue inclusion into the FTSE is more or less an automatic process (100 of the 110 largest stocks on London Stock Exchange). Thus, there is no certification going on.

Dayha's findings? There is a positive and permanent stock price jump on inclusion (about 1.86% on announcement and over 5% from announcement to inclusion). For deletions, there is only a temporary price drop.

"FTSE 100 Index additions reveal a permanent positive stock price response, whilst deletions are associated with a negative response, which is fully reversed over a 120 day-period after news of index removal. These results are consistent to those reported by Chen, Noronha and Singhal (2005), hereafter CNS (2005), on stock price effects to S&P 500 Index changes"

Why the price jump? It may be that firms in, or recently removed from, the index are under greater monitoring. In the author's words:

"...additions are associated with significant improvements in both realized and expected earnings (consistent with DMOY (2003)), and reduced information asymmetry as measured by a change in press coverage and Merton’s shadow cost (consistent with CNS (2005))."

"...deletions are not associated with a symmetric reduction in expected earnings or increase in information asymmetry. In fact, index deletions reveal a significant increase in realized and forecast earnings."

However, this price jump may have an economic rationale. Namely increased monitoring and better information.

"...It would appear that investors place increased scrutiny on the managers of firms added to and removed from the FTSE 100 Index."

Additionally, it fits well with Merton's shadow cost idea--namely that investors must be made aware of the stock. This awareness occurs upon inclusion. Deletion does not affect the awareness factor so the price should not be expected to drop back to its previous (pre-inclusion) level.

What is interesting (and really cool) about the paper is that the author then breaks down this price jump into component factors. For instance:

"...0.33 percent of the permanent stock price effect to index additions can be attributed to a change in future eps forecasts and a further 0.19 percent to changes in investor awareness (i.e., change in press coverage and shadow cost). Thus, the permanent stock price effect to index additions of 1.63 percent diminishes to an insignificant level after information effects have been stripped away."

Which deserves a wow! VEry cool. Definitely will find its way into class!!

Cite: Dahya, Jay, "Playing Footsy with the FTSE 100 Index" (January 11, 2006). Available at SSRN: http://ssrn.com/abstract=687465