The S&P 500 is not only the most widely used index for ETFs and funds, it is also the index of choice for researching markets. Much of the research focuses on the index pop — how much a stock jumps when it joins the index. About ten years ago some papers on comovement appeared arguing that index membership changes a stock’s behavior and affects the overall market. The gist of the argument is that two stocks of the similar size, valuation, sector and fundamentals will behave like one-other unless one stock is a member of the S&P 500 and the other is not. The claim is that when a stock joins the S&P 500, its returns comove with the rest of the S&P 500 index but do not fully reflect its fundamentals. Indices and index membership, not stocks, drive the market. Moreover, statistical evidence for comovement implied that the expansion of indexing was altering the way stocks behaved such that index membership mattered as much as fundamentals like earnings, dividends and book value; that index membership in the S&P 500 would raise the stock’s β.
Two recent papers dispute this view and show that stocks – and not index membership — are what matters. This new research explains why a stock’s fundamentals appear to shift when it is added to the S&P 500. There is a difference in the behavior of seemingly similar stocks observed when one of the stocks joins the S&P 500. The difference is seen in changes in the stock’s β and in higher EPS forecasts. However, this is not the result of some unexplained index membership effect that makes stocks in the index act like one-another or comove. Rather, the changes in a stock joining the index reflect the stock’s own performance in the period before it is added to the S&P 500.
Neither the S&P 500 nor the S&P 500 Index Committee alter the behavior of stocks. The driving force here is the way the market, on its own, shifts and the process that the Index Committee uses to identify stocks for the S&P 500. Stocks selected for the S&P 500 should have a market value of $5.3 billion or more and have positive earnings over the last four quarters. Since there are relatively few stocks outside the index that meet these requirements and since M&A activity continuously generates openings in the index, the place to find good candidates is among profitable growing companies. These companies often enjoy rising earnings and attract rising analysts’ estimates of future earnings. Moreover, as a stock’s price and market value increases its fundamentals, including its β, will change because it is shifting away from small cap and value towards mid or large cap and growth. The Index Committee is simply choosing stocks that meet the guidelines so that the S&P 500 continues to reflect the market.
The two recent studies are:
Maria Kasch and Asani Sarkar, “Is There an S&P 500 Index Effect?”, Staff Report No. 484, November 2012, Federal Reserve Bank of New York
Honghui Chen, Vijay Singal and Robert F. Whitelaw, “Comovement Revisited” June 2015, SSRN #2619736.
The often cited paper on comovement is Nicholas Barberis, Andrei Shleifer and Jeffrey Wurgler, “Comovement,” 75 Journal of Financial Economics (2005)