INDEX INCLUSIONS AND EXCLUSIONS: MEANING & IMPACT

An index in the context of financial markets is a statistical composite that tracks the performance of a basket of securities—typically stocks—representing a particular market or segment. Common indices include the S&P 500, FTSE 100, Dow Jones Industrial Average, and MSCI World. These indexes serve as benchmarks for investors to gauge market performance and often influence investment decisions through index-tracking funds such as ETFs (Exchange-Traded Funds) and mutual funds.

An index is generally compiled following a specific set of criteria, such as market capitalisation, sector, geographical representation, or liquidity. For example, the S&P 500 includes 500 of the largest publicly traded companies in the United States based on market capitalisation. The FTSE 100 comprises the top 100 companies listed on the London Stock Exchange by market cap.

Indices are maintained by firms such as Standard & Poor’s, FTSE Russell, and MSCI, and their composition is reviewed at regular intervals—monthly, quarterly, or annually. During these revisions, stocks may be added or removed based on whether they still meet the index’s inclusion criteria.

These additions and deletions are far from ceremonial; they can have material effects on the prices and trading volumes of the affected stocks due to changes in investor behaviour, index-tracking fund flows, and perceived sentiment about the company’s fundamentals.

When a company is added to an index, it becomes part of a widely tracked benchmark, meaning that index funds and ETFs that mirror the index will need to buy shares in that company. This usually results in a short-term spike in demand for the stock as institutional investors adjust their portfolios to match the index composition, potentially bringing about a higher share price and increased liquidity.

Conversely, when a firm is removed from an index, it becomes ineligible for those same funds. As a result, these funds are compelled to sell their holdings of that stock, which may exert downward pressure on the share price and reduce trading volume. Moreover, the stock might suffer from reduced analyst coverage and less visibility among international investors.

The mechanics of inclusion or exclusion vary slightly by index provider but generally follow a well-publicised schedule:

• Selection Criteria: Based on a combination of market cap, liquidity, domicile, and sector.
• Announcement Date: Typically occurs a few weeks ahead of the actual change date to allow for portfolio adjustments.
• Effective Date: The date on which the stock officially joins or leaves the index, often scheduled after market close on a specific trading day.

The timing and transparency of these actions mean that savvy market participants can anticipate and capitalise on the expected price movements tied to index rebalancing. For many, this also serves as a signal: an addition may be interpreted as a vote of confidence in a company’s fundamentals while a removal could be viewed, rightly or wrongly, as a downgrade.

It’s important to note, however, that the underlying business fundamentals do not change due to index status. A business is not inherently better or worse simply because it joins or exits an index—but the market reaction may tell a different story.

Inclusion in a major index tends to result in a positive price reaction in the short term. Various academic studies and empirical analyses have documented the phenomenon referred to as the ‘index effect’, which signifies the change in share price caused by increased demand stemming from index fund purchases. As index-tracking funds need to instantly reflect constituent changes, a stock scheduled for addition experiences strong buying pressure around the announcement and effective dates.

The magnitude of this effect can vary depending on the index’s breadth and the proportion of funds that passively track it. For example, joining the S&P 500 often has a more pronounced price reaction than joining a smaller or more narrowly defined index like the Russell 2000 or FTSE 250.

On the capital side, institutional demand increases, improving the stock’s liquidity and potentially reducing its bid-ask spread. Additionally, the company stands to gain in terms of visibility and credibility, which can translate into enhanced analyst coverage and broader investor interest. Analysts and investors alike often interpret inclusion as an endorsement of the company’s financial stability and future prospects.

Conversely, exclusion from the index can spark selling pressure by index funds and institutional investors who must sell the stock to maintain index alignment. This often causes a notable drop in price and volume, particularly in the days leading up to and following the effective date of the revision. Moreover, the company's liquidity may decline, and its stock may attract fewer institutional investors, posing challenges for future capital raising.

The index effect tends to be short-term in nature, with most of the price movement occurring around the rebalancing period. Long-term performance reverts to being driven primarily by fundamental business factors. Nevertheless, the index change may have longer-lasting implications in terms of investor perception and liquidity dynamics.

In addition to passive investor reactions, traders and speculators often try to front-run index changes by anticipating which stocks will be added or removed, further accentuating volatility during the rebalancing period. Such movements also affect derivative markets, particularly options and futures on the affected stocks.