|
...effects occur, disagreement exists about the explanation for these stock price reactions. (1)
More recently, a study by Chen, Noronha, and Singal (2004) documents an asymmetric price response to changes in the S&P 500: a permanent increase in the price of added firms, but no permanent decline for deleted firms. Their results support the investor awareness hypothesis that asserts changes in investor awareness contribute to the asymmetric price effects of S&P 500 Index additions and deletions.
According to Biktimirov, Cowan, and Jordan (2004), the inability of these prior studies to differentiate conclusively among the competing theories lies in the use of small sample sizes and other compounding issues. In an attempt to better differentiate among these competing explanations by enlarging the sample size, they examine the effect of index changes to the Russell 2000 Index from 1991 to 2000. As a consequence of using this index, Biktimirov, Cowan, and Jordan (2004) find significant, temporary increases (decreases) in price and volume for additions to (deletions from) the Russell 2000 Index, thus supporting the price pressure hypothesis.
In an attempt to reconcile the results of these two studies, we propose examining an index that captures the essence of both the S&P 500 Index and the Russell 2000 Index: the S&P 600 SmallCap Index. Utilizing the S&P 600 Index is advantageous for several reasons. First, the S&P 600 Index, like the Russell 2000 Index, is designed for tracking the performance of small capitalization stocks. According to Standards & Poor's:
The S&P SmallCap 600 is fast becoming the preferred small-cap index in the U.S., covering approximately 3% of the U.S. equities market. Measuring a segment of the market that is typically renowned for poor trading liquidity and financial instability, the S&P SmallCap 600 is designed to be an efficient portfolio of companies that meet specific inclusion criteria to ensure that they are investable and financially viable. As a result, the S&P SmallCap 600 is gaining wide acceptance as the benchmark of choice for both active and passive management. (2)
The Russell 2000 covers 2,000 companies comprising approximately 8 percent of total market capitalization, while the S&P 600 constitutes approximately 3 percent of total market capitalization. The average and median capitalization of firms in the two indices are similar. (3)
Second, changes to the S&P 600 Index are made in the same manner as changes to the S&P 500. Changes to S&P Indices are based on screening criteria including liquidity and financial viability. The S&P Index Committee monitors the various S&P indices components on a continual basis, making decisions concerning which stocks should be removed from, or added to, a particular index. In contrast, the components of the Russell 2000 index are reconstituted on an annual basis based entirely on market capitalization. Changes to the Russell 2000 are made simply because the relative market value of the firm grew or shrank.
In addition, Standard & Poor's pre-announces its index changes. Thus, an announcement effect exists as the period between announcement day and effective change day varies from one day to about one month. In contrast, the Russell 2000 constituents are formulated based on their market value on May 31 each year; however, reconstitution of the index does not occur until June 30, a month after the members are determined. Thus, there is no potential announcement effect on the reconstitution day because changes are known. Consequently, it is arguable that given the differences in methodology, the selection of a stock to or from the S&P 600 signals information to the investing public that is not signaled by inclusion in the Russell 2000.
Only a few studies have focused on the stock price effects of changes to an index comprising small capitalization stocks. Prudential Securities' analysts report that stocks added to the S&P 600 SmallCap Index in 1996 had positive average returns of 2.11 percent and that stocks moving from the S&P 600 to the S&P 400 increase on average 5.42 percent in value from the time of the announcement until the new listing (Napach, 1997). Bos (2000) looks at 403 additions to the S&P 600 index from its inception in 1994 through 1999. He finds that the average adjusted return from the announcement date to the effective change date is 5.40 percent, and from the effective change date to ten days after is -2.73 percent. Neither the Napach (1997) report nor the Bos (2000) study examine deletions from the S&P 600 Index, nor do they present any theoretical context or statistical findings.
Madhaven (2003) examines effects around the annual rebalancing of the Russell 2000 and Russell 3000 indices. He finds that additions to (deletions from) the indices experienced significant positive (negative) abnormal returns. These positive abnormal returns for the additions reversed in the month following the rebalancing. Madhaven (2003) concludes support of a temporary price pressure effect and a permanent liquidity effect.
Biktimirov, Cowan, and Jordan (2004) examine changes to the Russell 2000 indices from 1991 to 2000. They examine two types of additions and two types of deletions: i) Pure additions--additions to the Russell 2000 that were not previously in the Russell 1000, ii) Downward shifts--additions to the Russell 2000 that were downward shifts from the Russell 1000, iii) Pure deletions--deletions from the Russell 2000 that were not shifted to the Russell 1000, and iv) Upward shifts--deletions from the Russell 2000 that were upward shifts to the Russell 1000. Results for pure additions (deletions) reveal a positive (negative) reaction on reconstitution day that reverses completely; thus supporting a temporary price pressure effect. Results for downward shift additions are negative and permanent. Results for upward shift deletions are positive and permanent.
In summary, our study contributes in two major ways. First, we contribute by providing rigorously developed information concerning the effects of additions to and deletions from the S&P 600 and place those findings into a theoretical context. Second, we attempt to reconcile the conflicting results in the Biktimirov, Cowan, and Jordan (2004) study, which supports the price pressure hypothesis, and the Chen, Noronha, and Singal (2004) study, which supports the investor awareness hypothesis.
Hypotheses
Authors analyzing index changes have focused on several possible explanations for resulting price movements: downward sloping demand curve hypothesis, liquidity hypothesis, price pressure hypothesis, the information content hypothesis, and the investor awareness hypothesis. These hypotheses are equally applicable to the S&P 600 Index.
The timeline in Figure 1 illustrates the various event dates and windows referred to in the various hypotheses:
1. The effective announcement date (ADO);
2. The arbitrage opportunity window which runs from the first day able to trade on information (announcement day, ADO) through last day able to trade on information (CD-1);
3. The effective change date (CD0); and
4. The post-change date permanent effect window, which runs from and includes the change day (CD0) to some day in the future (CD+x).
[FIGURE 1 OMITTED]
Downward Sloping Demand Curve Hypothesis and Liquidity Hypothesis. Lynch and Mendenhall (1997) and Shleifer (1986) believe in the possible existence of downward sloping demand curves for stocks. This theory states that, in the case of additions to the S&P 600, buying by index-fund managers attempting to mimic the S&P 600 index removes a substantial fraction of the firm's shares from circulation. This demand by index fund managers reduces the stock's supply for non-indexing investors, causing the market-clearing price to increase permanently. Such buying represents an outward shift of the demand curve for the firm's equity.
If the long-term demand curve were horizontal, inclusion of a stock in an index would not be accompanied by a price increase and no permanent price effect would be expected. In contrast, with a long-run, downward-sloping demand curve, you should observe a price increase on the announcement date that should be permanent in nature persisting past the effective change date (Shleifer, 1986).
For deletions, analogous logic predicts a price decrease: as stocks leave the S&P 600, index-fund selling adds to the number of shares in circulation, which leads to a decrease in demand and an increase in the stock's supply for non-indexing investors, causing the market-clearing price to decrease. Such selling represents an inward shift of the demand curve for the firm's equity.
The liquidity hypothesis states that the addition or deletion of the stock from the index alters the stock's liquidity, which affects its price. Beneish and Whaley (1996) and Shleifer (1986) agree that analysts, investors, and institutions may scrutinize newly added stocks more fully; hence, the firm's information environment becomes richer and its stock trades more actively. This...
NOTE: All illustrations and photos
have been removed from this article.
More articles from Quarterly Journal of Business and Economics
Selection of the scale measure in narrow money demand: the cases of Ja..., January 01, 2006
Looking for additional articles?
Search our database of over 3 million articles.
Looking for more in-depth information on this industry?
Search our complete database of Industry & Market reports by text, subject, publication
name or publication date.
About Goliath
Whether you're looking for sales prospects, competitive information, company
analysis or best practices in managing your organization,
Goliath can help you meet your business needs.
Our extensive business information databases empower business
professionals with both the breadth and depth of credible,
authoritative information they need to support their business
goals. Whether it be strategic planning, sales prospecting,
company research or defining management best practices -
Goliath is your leading source for accurate information.
|
