Academic journal article The International Journal of Business and Finance Research

Analysis of the Effects of Pre Announcement of S&p 500 Index Changes

Academic journal article The International Journal of Business and Finance Research

Analysis of the Effects of Pre Announcement of S&p 500 Index Changes

Article excerpt

ABSTRACT

In this study we attempt to answer the question - does the start of pre-announcing of S&P 500 index changes in October 1989 have an effect on the trading pattern of added or deleted firms? We document that prior to October 1989 the excess returns of added or deleted firms follow a white noise process around the event, whereas after the start of pre-announcing the excess returns can be described as non-stationary. This indicates significant excess profits to be captured around the addition or deletion event after S&P started pre-announcing changes in October 1989 but not prior to that date.

JEL: G12; G14

KEYWORDS: S&P 500 Discretionary Deletions, S&P 500 Changes, Excess Returns

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

The S&P 500 index consists of 500 large cap stocks and is the most prominent index in capital markets. In a press release to Reuters on October 1, 2012 the S&P Dow Jones Indices LLC, a subsidiary of The McGraw-Hill Companies, Inc., states: "The S&P 500 is widely considered the premier gauge of the overall health of the U.S. equity market and the leading gauge of large-cap equity performance in the U.S. Over $5.5 trillion is benchmarked to the S&P 500 with index assets comprising approximately $1.3 trillion of this total. The Index includes 500 leading companies and captures approximately 80% coverage of available market capitalization." Considering the vast sums of money linked to the S&P 500 a simple change in the constituents of the index is usually associated with large swings in the added or deleted firm's stock price due to the trading of managers of index funds linked to this index. The S&P US Indexes Committee clearly states in their index methodology, available at http://www.standardandpoors.com, that the addition or deletion of a firm from the index does not indicate a change in fundamentals of the firm and does not imply an investment advice on their part.

In October 1989 the S&P US Indexes Committee started pre-announcing changes to be made to the S&P 500 index. The reason S&P started pre-announcing the index changes is to alleviate the order imbalances created by index funds' demand for shares to rebalance their portfolios. Prior to October 1989 the S&P US Indexes Committee made the changes without pre-announcing. In this study we attempt to answer the question - does the start of pre-announcing of S&P 500 index changes in October 1989 have an effect on the trading pattern of added or deleted firms? We use excess return methodology to test whether predictable patterns in stock returns can be discerned around the event of addition or deletion.

To the best of our knowledge this is the first study to address this question on an excess return basis. We document that prior to October 1989 the excess returns of added or deleted firms follow a white noise process around the event, whereas after the start of pre-announcing the excess returns can be described with a non-stationary process. This indicates significant excess profits to be captured around the event after October 1989 but not prior to that date. This study extends our knowledge in the field of indexing but also raises questions that hopefully will lead to changes that would help the market become more efficient. The remainder of the paper is organized as follows: section 2 examines the relevant literature. Section 3 describes the data and empirical methodology to be used in the study. Section 4 presents the paper results and Section 5 offers concluding remarks.

LITERATURE REVIEW

Additions and deletions to the S&P 500 index are managed by the S&P US indexes committee. In contrast to the rest of the capital market indexes the S&P 500 is not reconstituted annually or semiannually and is not purely based on market capitalization. To be considered for inclusion in the S&P 500 a firm needs to meet certain criteria. …

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