Interactive Investor

Does joining an index help or hurt a stock?

26th August 2020 11:43

Tom Bailey from interactive investor


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The expected inclusion of Tesla in the S&P 500 is a likely contributor to the company’s recent share price surge. 

Recently there has been a lot of talk about changes to the companies included in big indices. I recently looked at the prospect of Tesla joining both the S&P 500 and the Dow Jones, and what that tells us about how those indices are constructed. 

We are still waiting on news of whether Tesla (NASDAQ:TSLA) will be added to the S&P 500. However, the electric car-maker has missed out on inclusion in the Dow Jones, with the index recently announcing changes that would see Salesforce (NYSE:CRM) enter the index and Exxon Mobil (NYSE:XOM) depart.

It is generally understood that inclusion in big indices is good for a company’s share price. Billions of dollars around the world is invested in index funds and ETFs that track these indices. When a company such as Salesforce is added to the Dow Jones, funds such as the iShares Dow Jones Industrial Average ETF (LSE:CIND) have to buy Salesforce shares to continue to replicate the index. That should push up prices.

However, markets are always attempting to anticipate the future. If it looks like a company will be included in an index, its share price will likely have risen to reflect that. The expected inclusion of Tesla in the S&P 500 is a likely contributor to the company’s recent share price surge. Although, in the case of market-cap weighted indices (like the S&P 500 but not the Dow Jones), the share price of a company has to have increased, at least relative to other shares, to warrant talk of inclusion. 

But beyond these initial questions of index fund inflows, what is the wider impact of inclusion on share prices? This is addressed in a new paper Testing the Theory of Common Stock Ownership by Lysle Boller of Duke Univesity and Yale University's Fiona Scott Morton. The paper argues that inclusion in the index is good for both the new entrant and some incumbents in the index due to the theory of “common stock ownership”.

The theory of common ownership goes something like this. Traditionally companies had shareholders who saw it as in their interest to pressure management to pursue strategies to maximise the firm’s revenue. The most obvious way to do this is to sell more of your product. However, unless you have a very new and innovative product, this increase in sales often comes at the expense of your competitors. So, companies engage in competition with one another for a share of the market for the specific product they provide.  

However, with the advent of modern asset management, particularly in the form of ETFs and index funds, that has changed somewhat. Companies in the major indices (such as the FTSE 100 or S&P 500) are now likely to find themselves owned by a handful of the same big asset managers. In effect, they have the same shareholders.

This, in theory, makes companies less likely to compete for market share. If one company lowers prices, others follow suit to defend their market share. If one company is developing a new and better product, other companies must spend more on research and development to try and keep up. This can work out well for the company that comes out on top of the competition and, by extension, its shareholders.  

But this is also expensive and eats into the profits of the competing companies when looked at as a whole. As a result, such competitive behaviour may not be welcomed by shareholders who also have holdings in competitors. Owning the company that wins a price war is good; owning all the companies engaging in a price war over the same market is not so good. So, such shareholders have less desire to see the companies they own compete with each other. Management at these companies know this and act accordingly.

The truth of this theory is hotly debated. Academics have previously published work suggesting that airlines in the US may be reluctant to engage in price-based competition for this reason. Critics, however, argue that the mechanism for shareholders telling managers not to compete does not exist.

One way to test this theory is to look at what actually happens to both the share price of a company when it is added to a major index and that of its competitors already in the index. If the theory has any truth to it, the share price of both the new entrant and the competitors should benefit.

The most important part of this, however, is whether the share price of companies already in the index benefit. After all, the company being added to the index will start to see an increase in share ownership by the same big asset managers (increasing its “common ownership”). In theory, the company should now start to behave in a less competitive way. So, essentially, the companies already in the index have lost a competitor, which is good for their share prices.

So, the recent paper by academics Boller and Morton is instructive. The paper looked at incidences of shares entering the S&P 500 index and identified their competitors already in the index.

As expected, inclusion in an index was good for the new company’s share price. But most importantly, they also found that having a competitor included in the index is good news for its rivals. The academics note: “Most strikingly, we find that competitors who are themselves index incumbents incur higher abnormal returns upon the entry of their rivals when compared with non-incumbent competitors.

“This finding is supported by a null result for two control groups. Entrants that do not experience an increase in institutional ownership do not generate similar spill-over effects to their rivals, and competitors that are not index incumbents do not incur higher abnormal returns.”

So, yes, inclusion in the index is generally good for new listings, but also for competitors, potentially owing to common ownership. Of course, plenty of other papers have been published that conclude the opposite. With the continued growth of ETF and index fund investing, the debate will continue.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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