The index inclusion effect is dead

Here in the UK, we will get the announcements of the first index review of 2025 for the FTSE indices later today. The index changes will be implemented on Monday, 24 March at which point index trackers will have to buy the new entrants and sell the index deletions. Time then for companies to issue some shares.

It may sound weird, but index revisions create inelastic demand for a company’s shares, and this creates an opportunity for companies to sell shares held in Treasury or issue new shares without having to worry that this will drive down the share price. If that sounds cheeky, it seems that it has been going on without much fanfare for some time in the US.

Tommaso Tamburelli from Boston College looked at the S&P 500 and the share issuance of companies that were newly included in the index. He found the below pattern of new share issuance in the days around the index inclusion. In total, companies that enter the S&P 500 issue some 1% of their share capital in new shares on the day after the inclusion.

Daily share issuance around S&P inclusion

Source: Tamburelli (2024)

This behaviour suggests a reason why the index inclusion effect has largely disappeared in the last decade or so. In the past, when a company was promoted to an index, its shares tended to rise in the immediate aftermath of the index change as funds that tracked the index and active managers using the index as a benchmark bought shares of the new index member. If companies issue new shares to take advantage of this abnormal demand, they are effectively pushing these abnormal returns down and reducing or eliminating them.

There is even a second-order effect. In anticipation of this index inclusion effect, hedge funds tended to buy stocks of companies that were about to be included after the index provider announced the index changes. There typically is a two-week gap between the announcement of the index changes and the actual inclusion, which gives hedge funds a trading window to exploit the index inclusion effect.

But companies seem to have wised up to that as well because they issue new shares already after the index changes have been announced. The chart below shows that in the two weeks after the index changes have been announced (but before the stock is included in the index) companies that newly enter the S&P 500 issued up to 0.5% of their share capital in new shares per day.

Daily share issuance around S&P index announcements

Source: Tamburelli (2024)

The index inclusion effect is being arbitraged away by the companies themselves and all that is left is for traders to speculate on what kind of announcements the index provider could make, which is much more uncertain and a far cry from the original arbitrage opportunity.