The Index Inclusion Effect in S&P 500: A Quantitative Research of Stocks’ Reactions to Index Inclusion

Abstract

This thesis investigates the development and contemporary dynamics of the index inclusion effect in the S&P 500 index. Specifically, we use an event-study methodology to analyze abnormal returns from ten days prior to an announcement of a stock inclusion in the index until seventy-five days post the actual inclusion date. Additionally, we employ a cross-sectional regression for the identified abnormal returns to reveal relationships between the degree of abnormal returns and independent variables that reflect net demand- and time-varying effects. We find that abnormal returns were high and statistically significant on the announcement date, persisting until the actual inclusion date in the period from 1989 to 2006. However, this effect diminished after 2007 and became statistically insignificant from 2016 to 2023. The abnormal returns from 1989 to 2015 align with the price pressure hypothesis by Harris and Gruel (1986), suggesting that the buying pressure from index-tracking funds temporarily increases stock prices to compensate liquidity providers. Yet, from 2016 to 2023, this hypothesis loses explanatory power as the abnormal returns vanish. To find explanations for this shift, we identified a significant relationship between abnormal returns and variables impacting net demand, as well as time-varying effects. The changing net demand, primarily due to stocks migrating from the S&P 400 and their decreasing relative weight in the index, appears to be a primary reason for the evolving index effect. However, we also find that high pre-inclusion abnormal returns may suggest that investors have improved at predicting and front-running the index effect, presenting an important alternative explanation. Our findings identify several factors that contribute to the diminishing effect, but they are not entirely definitive, as we cannot establish a clear causal relationship. Nonetheless, they underscore important aspects that have not been paid much attention to in existing literature. To further validate these explanations, we recommend complementary event-study research into the dynamics of the S&P 400 or S&P 600 to explore net-demand shifts or investigation of stock patterns and investor behavior before inclusions to explain these evolving market trends.