Interactive Investor

FTSE 100 reshuffle: do promotions further boost share prices?

1st September 2020 10:41

Tom Bailey from interactive investor

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We explain why firms promoted to the FTSE 100 index can enjoy an extra uplift in their share price.

When a company is promoted to a market capitalisation-weighted index such as the FTSE 100, it is because the share price has increased, at least relative to other companies. Likewise, demotion from an index is usually because of a fall in share prices. However, price increases and decreases do not always stop there.

At the time of writing, ahead of the FTSE 100 reshuffle being finalised at close of trading today (1 September), B&M European Value Retail (LSE:BME) is likely to join the FTSE 100 and ITV (LSE:ITV) is expected to drop out.

Generally, being promoted to a major index such as the FTSE 100 also brings with it a further increase in price. The simple reason for this is that inclusion in a major index means that a lot of large funds have to buy the recently added shares.  

First, a reshuffle means that passive vehicles, such as index funds and ETFs, have to adjust their portfolio. Behind the scenes, a lot of work goes into ensuring that portfolios match the index they are trying to track.

Most of this work is done when the FTSE 100 experiences a reshuffle. Fund managers will have to buy enough of the newly added shares so that their portfolio resembles the newly reshuffled index. In turn, this pushes up the price of shares that are promoted to the index. Likewise, when a company is removed from an index, passive funds sell shares, creating downward pressure on prices.

But it is not just passive managers. Active fund managers using the index as a benchmark may also feel the need to buy any new additions to the index and sell those that are removed.

Fund managers measure their performance against an index such as the FTSE 100. To guard against underperformance, some fund managers ensure that their holdings do not deviate too much from their benchmark. For some, this will mean holding a large portion of the index, but with different weightings to the stocks they feel more positive or negative about. So, this process also means new buyers for a stock when it is added to the index.

In a similar vein, when a stock is removed, it is no longer part of the benchmark, which could encourage some fund managers to sell. In other cases, the fund’s investment mandate might restrict holdings to only those found in the index, meaning demotion from the index requires the fund manager to sell.  

However, before investors rush out to buy or sell shares that they suspect will be promoted or demoted in the quarterly re-shuffle, they should keep in mind that prices may already reflect these expectations. Markets are forward-looking and if it is expected that a certain company will be added and experience inflows from passive funds and active fund managers paying close attention to the index, other investors may have already bid up the price. Likewise, investors may have sold shares in advance of an expected demotion of a company from the index.

Even if investors are not able to always benefit from an immediate jump in the share price that comes from being added to the index, inclusion does create a large and stable pool of buyers and holders, which, in theory, is good news for the firm’s share price.

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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