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...firms. addition, the matching-firm price reaction is negatively related to the added firm's weight in its industry. These findings suggest that the index addition conveys favorable information about the added firm and its industry.
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The positive price effects of the firms added to the Standard and Poor's 500-stock index (S&P 500) have been a interesting research subject in the finance literature since first studied by Shleifer (1986), Harris and Gurel (1986), and Jain (1987). However, the question of what drives up the stock price remains unsettled. There are at least two competing hypotheses on the subject, the information hypothesis and the downward sloping demand curve hypothesis.
According to the information hypothesis, the S&P 500 index addition conveys favorable information about the added stock to the market, and the new information drives up the stock price. Although S&P repeatedly claims that index additions do not "in any way reflect an opinion on the investment merits of the company," several authors find evidence supporting the information hypothesis. (1) Jain (1987) finds positive announcement price effects of stocks added to the S&P supplementary indices, which were not followed by index funds during the period of his study. Dhillon and Johnson (1991) find that the call options and bonds of firms added to the S&P 500 also react positively to the announcement. Denis, McConnell, Ovtchinnikov, and Yu (2003) find that the added firms experience significant increases in both analyst earnings forecasts and realized earnings.
According to the downward sloping demand curve hypothesis, when a stock is added to the S&P 500, the additional buying demand from index funds drives up the stock price if the demand curve of the stock slopes downward. (2)
Disentangling the price effects of the two hypotheses can be difficult, since both hypotheses predict the same price reaction for the added stock. Therefore, I study the price and volume reaction of the industry and size matching firms of the added firms. The advantage of studying the matching firms is that they are not subject to the excess demand induced by the index additions. Thus, the price reactions of these firms are unlikely to be the result of the downward sloping demand curve. In addition, the benefits of S&P 500 membership, such as improved liquidity or investor awareness, do not affect the matching firms. Therefore, the price effects of these matching firms, if any, most likely reflect the favorable information about the industry and size segment represented by the firm added to the S&P 500. However, the matching-firm price effects do not capture the firm-level information content of the index additions, so the total price effects of the new information conveyed by the index additions are likely to be greater than what I document in this study.
The S&P 500 index additions may convey new information to the market for two reasons. First, "the guiding principle for inclusion in the S&P 500 is leading companies in leading US industries" (see Bos and Ruotolo, 2000, page 3). When a firm is added to the index, S&P certifies it as a leading firm, and certifies the industry of the firm as a leading industry. Even if S&P makes the index addition decisions based entirely on public information, it may simply have superior analytical skill. Thus, the stock price of the added firm and other firms in the same industry may react positively to the announcement.
Second, index changes require index funds to sell the deleted firms and buy the added firms, which can substantially increase the transaction costs and tracking error of the index funds. Thus, frequent turnover makes an index less attractive to the index funds. S&P certainly wants to retain its index licensing business and believes "that unnecessary and excessive turnover in index membership should be avoided when possible" (see Blitzer, 2003, page 2). To reduce the index turnover, S&P may select firms that it believes will be able to meet the index criteria for longer periods of time. Indeed, S&P acknowledges that index inclusion "does include the assumption that the company is going to remain in business" (see "S&P 500 Index Methodology," Section 3, page 39). Furthermore, S&P may also select firms from the industries that it believes will have greater representation in the economy in the future, since this may help reduce future index changes. Therefore, the S&P 500 additions may convey information about the added firms and their industries.
In this study, I focus on the information content of S&P 500 additions at the industry level rather than the firm level. Specifically, I form three matching-firm samples based and two-, three-, or four-digit SIC codes and size. It is necessary to match by size, because S&P 500 is an index of large stocks, and therefore the information conveyed by S&P 500 additions are likely to be about the large stocks in an industry.
I find that the industry and size matching firms of the firms added to the S&P 500 react positively to the index addition announcement. Although the magnitude of the matching-firm price reaction is relatively small, it captures only the segment-level information content of the index additions. The firm-specific information content can have greater price effects. In addition, the matching-firm price effect may be dampened by the increased competition from the added firm.
To disentangle these effects, I investigate how the added firm's weight in its industry affects the matching-firm price reaction and I find a negative effect. This result suggests that the S&P 500 index additions also convey favorable...
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