NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Stock Price Reactions to Index Inclusion

When a company from the Russell 1000 just makes it into the Russell 2000, its share price rises compared to that of a company that narrowly missed making it in. The reverse move triggers a stock price decline.

The impact on companies' share prices of being included in a stock index, such as the Standard and Poor's (S&P) 500, has long been analyzed and debated. In Regression Discontinuity and the Price Effects of Stock Market Indexing (NBER Working Paper No. 19290), Yen-cheng Chang, Harrison Hong, and Inessa Liskovich find that when a company moves from the Russell 1000 to the Russell 2000, its share price rises. The reverse move triggers a stock price decline. These findings provide support for the view that index inclusion can affect demand for a company's stock.

Past studies have found that companies added to the S&P 500 experience increases in their share values, and yet recent studies with the largest samples also have shown that there are no corresponding declines in share values when firms are deleted from that index. That seeming paradox has led some to conclude that the share-price increases might not only be tied to buying by passive stock-index funds or institutional investors who are benchmarked to various indexes. Rather, the spike in share prices might be associated with an increase in earnings forecasts and improvements in realized earnings at the time a firm is added to an index. Also, some scholars have theorized that lingering "investor recognition" of firms that were once on an index may partially explain why their share prices don't fall after deletions.

The authors attempt to resolve this puzzle by comparing firms that just made it into the Russell 2000 index to those that just missed making it in. The Russell 1000 is a value-weighted stock index comprising the 1,000 largest firms by market capitalization; the Russell 2000 is a similar index that includes firms 1,001 to 3,000. The two indexes are based on end-of-May market capitalization calculations. Small changes in the market capitalizations of firms that are ranked near 1,000 can move them from one index to the other. The authors analyze the trading and share prices of companies that moved back and forth between the two indexes from 1996 through 2012.

Because the indexes are capitalization-weighted, there is relatively little index buying when a firm enters the Russell 1000 as one of the smallest firms, but there is non-trivial buying when a firm joins the Russell 2000 as one of the index's largest capitalized firms. Indeed, the authors found the index weights for the stocks in the Russell 2000 just below the 1,000 cutoff (stocks 1,001 to 1,110) are around ten to fifteen times larger than the index weights for stocks just above the 1,000 cutoff (stocks 990 to 1,000).

In contrast to past S&P 500 studies, the authors also found a deletion effect for stocks whose market capitalization bumped them up from the heavily-traded top echelon of the Russell 2000 to the less heavily traded bottom of the Russell 1000. Stocks with such upward movement experienced lower returns than stocks that stayed on the Russell 2000.

The authors also found that Russell 2000 inclusion results in more trading in June, after end-of-May capitalizations are calculated, and that activity is consistent with investors rebalancing and tracking stocks. The just-added stocks have more trading volume than stocks that just missed addition to an index, while the just-deleted stocks have more trading volume than stocks that stayed in the index.

--Jay Fitzgerald

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