Asymmetric Changes in Stock Prices and Investor Recognition around Revisions to the S&P 500 Index

Haigang Zhou

Financial Analysts Journal, 2011, vol. 67, issue 1, 72-84

Abstract: This study finds that first-time additions to the S&P 500 Index or its family experience permanent price increases; however, companies upgraded from lesser-known S&P indices, reentering the S&P 500, or dropped from the index experience temporary price changes. These price patterns can be explained by changes in investor recognition.Previous studies have found that stock prices increase after companies are added to the S&P 500 Index and drop after companies are removed from it. Moreover, the price increase is permanent for additions and the price drop is temporary for deletions. These asymmetric price effects are consistent with the investor recognition hypothesis. After companies are added to the S&P 500, their level of recognition among investors increases. But investor recognition does not easily diminish after companies are dropped from the index.Added and deleted companies have different pre-addition and post-deletion statuses. Changes in investor recognition are arguably different between first-time additions to the S&P 500 (as well as to the S&P index family) and companies that are upgraded to the S&P 500 from lesser-known S&P indices. But changes in investor recognition are arguably similar between deletions that are downgraded to lesser-known S&P indices and those that are dropped from the entire S&P index family. Are changes in stock prices different across the companies? The answer is important for investors, especially enhanced index fund managers, who want to optimally time the trading of shares of S&P 500 additions or deletions.I identified three samples of companies with different pre- and post-event statuses and studied their price changes. First-time additions to the S&P 500, as well as the S&P index family, experienced higher and permanent price increases, whereas companies upgraded from other S&P indices observed lower and temporary increases in stock prices. Similarly, share revaluation for first-time additions to the S&P 500 was higher and permanent, whereas that for companies reentering the index was lower and transitory. But deleted companies recovered all the losses resulting from the announcements 40 days after Standard & Poor’s implemented the changes, regardless of their post-announcement status. The implication for investors and enhanced fund managers is that they can benefit from postponing the purchase of shares of added companies if the companies are transferred from lesser-known S&P indices or if they are reentering the S&P 500 but not if the companies are newly added to the S&P index family or if they are entering the S&P 500 for the first time. For deletions, regardless of their post-deletion status, investors can benefit from postponing the sales of shares of deleted companies.Does the investor recognition hypothesis explain these patterns of price changes? Using three proxies—Merton’s shadow cost, analyst coverage, and ownership breadth—I examined the changes in investor recognition around revisions in the S&P 500. First-time additions to the S&P index family and to the S&P 500 have a greater increase in investor recognition—a greater decrease in shadow cost, a greater increase in analyst coverage, and a greater increase in number of shareholders—than do companies upgraded from other S&P indices and companies reentering the S&P 500. Companies that are dropped from the entire S&P index family have greater increases in shadow cost and lose more analyst coverage and shareholders than do companies downgraded to lesser-known S&P indices. Therefore, my findings are consistent with the investor recognition hypothesis.

Date: 2011
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DOI: 10.2469/faj.v67.n1.1

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