Even if you know nothing about investing, you've probably heard of the S&P 500 and Dow Jones industrial average. Stock indices are baskets of companies which represent a specific market sector or industry. With the rise in popularity of investing in stock index funds, the demand for the individual component stocks is increased, so inclusion in an index will nearly automatically increase the price of the stock.
Supply and Demand
The main cause of the jump in the price of a stock in an index is an increase in demand. Suddenly, this stock hits the prime time and every index fund manager needs to buy. This is going to be a one-time "information-free" jump in price until each index fund gets the correct amount of the stock. The actual valuation of the company itself is unchanged, and future earnings and revenue will be unaffected.
Not all indices are created equal. There are 30 stocks in the Dow, while the Wilshire 1000 has, you guessed it, 1,000 stocks. The number of shares acquired is going to vary drastically in line with the percentage of the total assets represented by the new stock. In some of the larger funds, the managers might not even buy every component because of the high transaction costs. They may choose to use derivatives to obtain coverage, in which case inclusion may lead to a small but permanent increase in the price.
Equity Index Funds
Equity index funds have been popular for many years due to low management fees and financial market developments which make it more difficult for active fund managers to beat these passively managed funds. The amount of stock in the new company purchased by fund managers is directly related to the company's weight in the index. If the new stock is 2 percent of the value of the index, then index fund managers must shift 2 percent of assets into the stock.
The timing of the announcement and the inclusion date are key. Each index announces its changes in advance, but index funds cannot acquire the new company until the effective date of the change. In the interim, other market participants may buy in expectation of a big price jump on the effective date. However, once index funds purchase their required positions, the stock price will maintain a new higher price level and there will be no additional effect on price due to inclusion.
Inclusion in the index will result in a higher "base price" for the stock, and further price changes will be a result of news such as company performance. Going forward, the stock likely will have increased volatility due to so many transactions being index-related and not because of intrinsic expectations about the company itself. In addition, there should be higher trade volumes and possibly an even higher level of demand due to increased visibility for the company, assuming its profitability outlook remains positive.
Naomi Smith has been writing full-time since 2009, following a career in finance. Her fiction has been published by Loose Id and Dreamspinner Press, among others. She holds a Master of Science in financial economics from the London School of Economics and a Bachelor of Arts in political economy from the University of California, Berkeley.