Can value can be added to a portfolio through equity index additions and deletions? The authors study the German equity market and find a temporary price run-up for index additions. Surprisingly, index deletions earn significantly higher abnormal returns than index additions in the five-year post-event period the authors study.
How Is This Research Useful to Practitioners?
Prior research has shown that there is a wealth transfer of roughly $2 billion a year from investors to arbitrageurs during the reconstitutions of the S&P 500 and Russell 2000 indexes. In the DAX indexes, the authors find opportunities to significantly enhance returns. Their findings demonstrate a strong run-up in German share prices preceding index addition announcements, but this effect remains until only two months after the effective date and reverses completely five months later. The authors’ research supports the idea that companies are added to the index during their peak performance stage and fall short of market expectations in the long run.
This research is helpful for index fund managers who need to consider timing trades of stocks affected by index reconstitutions. A passive approach to additions often results in the purchase of overpriced, lackluster shares in large-cap companies but still adds value in small caps. Global portfolio investment guidelines may require larger tracking variances to realize these abnormal returns that deleted DAX stocks earn compared with added DAX stocks.
The authors find that although there is temporary price pressure on deleted stocks from the DAX portfolio, it subsides within 10 months of the exit date. Their model shows that deleted stocks outperform added stocks by 77.3% over a five-year period from the effective date. When examining individual sectors, the authors find that share demotions from either the SDAX (small cap) or TecDAX (technology) indexes result in permanent negative stock price responses.
How Did the Authors Conduct This Research?
The authors examine four of the Deutscher Aktien Indexes, which trade on the Frankfurt Stock Exchange: large cap (DAX), mid cap (MDAX), small cap (SDAX), and technology (TecDAX). The final sample consists of 194 additions to and 313 deletions from these indexes. The authors analyze a short-term effect (less than 63 days) and a long-term effect (more than five years). To bypass the small sample size constraint, they combine DAX and MDAX.
The authors carefully distinguish events as outright entries, outright exits, promotions (from a smaller-cap index), and demotions (to a smaller-cap index.) Cumulative abnormal average returns are calculated under several short-, mid-, and long-term time frames and reviewed for price effects. Potential drivers of abnormal returns are proposed and examined.
To explain the large, long-term outperformance of deletions compared with additions, the authors run a regression using the following variables: cash holdings, information quality, liquidity, institutional ownership, company visibility, analyst coverage, press coverage, quoted bid–ask spreads, and changes in operating performance. They find that price effects result from differences in media coverage and long-run changes in operating performance. There is a strong rebound in the deleted stocks’ operating performance beginning in the year following their deletion, whereas a deterioration occurs for added stocks within two years of being added.
Abstractor’s Viewpoint
The authors have produced a comprehensive study of index reconstitution price effects, but some institutional investors may fail to benefit from this research because of restrictions on portfolio turnover and short-term performance targets. The typical three-year time horizon of institutional investors restricts their ability to take full advantage of the five-year return enhancement. If the authors were to duplicate their research results in other major global equity indexes, it might justify moving to a five-year performance target for fund managers.
In 2016, the Deutsche Börse Group announced that the entry/exit rules for the MDAX, SDAX, and TecDAX would become completely automated (there had been room for discretion previously). Because the authors’ dataset ended in 2013, it would be interesting to update the research under these new rules.