Index Changes Don’t Charge Up Stock Returns

Editors’ Note: MarketMinder doesn’t make individual security recommendations. All references to specific stocks included herein are made exclusively to illustrate a broader point.

Monday, index provider S&P Dow Jones made waves, announcing electric car manufacturer Tesla would join America’s flagship stock index, the S&P 500. This move has been widely anticipated for months, particularly as the firm gradually met more and more of the index’s requirements. Tesla met the final one, turning a positive profit in the trailing four quarters, in Q3 2020—driving^[i] the index provider’s decision. The stock celebrated this move with a three-day surge on Tuesday, Wednesday and Thursday, rekindling a long-running theme among pundits: That index changes are super bullish, with many guessing at which stocks are next. To us, this doesn’t hold water. While anything can happen with Tesla, the car maker stock that doesn’t trade like a car maker, gaming index changes isn’t likely to generate repeat wins.

The theory seems logical enough. Adding a stock or set of stocks to an index should boost demand for the shares. After all, the change would force passive managers to buy. Many active managers would likely also follow suit, given they may want to reflect a change to the benchmark (depending on how notable this is). S&P Dow Jones estimates there is over $4.6 trillion in passive money mirroring the S&P 500 and another $6.6 trillion in active money benchmarked to it.^[ii] That sounds like a lot of money chasing new additions—plenty of demand to drive outperformance.

The trouble is, the data don’t support the notion a stock being added to the S&P 500 turbocharges its price. In the last three years, Tesla is the 53^rd stock added to the gauge.^[iii] Our review of these data show that, excluding Tesla and one firm that underwent a merger after inclusion, average and median returns trail the S&P 500 itself in the short window between the announcement and the effective date by 0.12 and 0.75 percentage point, respectively.^[iv] Six months after the effective date, the 45 new additions with sufficient trading history lag the index by an average 2.1 percentage points and a median 5.9 percentage points. A year out? The 36 stocks with enough history trail the S&P 500 by 6.6 and 8.4 percentage points, respectively. This is not what you should expect if you believe chasing index moves “works.”

Although our broad survey of financial media suggests we are in the minority, we aren’t the only researchers to reach this conclusion. National Bureau of Economic Research scholars Benjamin Bennett, René M. Stultz and Zexi Wang penned a working paper in July that studied new additions to the S&P 500 over the period 1997 – 2017.^[v] They found that there was generally a positive performance effect in the first half of their study period, but it waned and flipped negative in the second half. To us, that makes a lot of sense when you consider how adaptive markets are to common theories. If there was an edge to trading on the news of an index addition, too many market participants caught on. It seems to be gone.

This further makes sense when you consider index providers’ inclusion criteria are published in advance. Therefore, investors watching this can monitor when a security reaches or falls below required criteria. This spring, that had many investors wringing their hands over the S&P 500’s structure, as loads of firms fell below the minimum market capitalization threshold during the bear market caused by COVID lockdowns. (Criteria the index provider temporarily ignored.) It is also why so many people were watching Tesla for potential inclusion.

This same logic applies when global index providers like MSCI reclassify countries from Frontier to Emerging Markets, Emerging to Developed or what have you. Such decisions tend to follow returns more than they lead them, meaning they don’t offer an “easy button” to outperformance.

Again, none of this should be taken as a “bull” or “bear” case for Tesla. We don’t do that on these pages. Besides, its future movement will likely depend more on the company’s fundamentals, economic trends and how those relate to sentiment. Our point is that the broader practice of hunting for stocks to be the next ones to jump big after inclusion in a major index is fatally flawed. So whatever your view of Tesla, it shouldn’t hinge on the decision S&P Dow Jones made earlier this week.