The Past, Present, and Future of the Index Effect

Abstract

We revisit the long-documented index effect, whereby stocks that are added/deleted to major indices experience positive/negative excess returns around the date that the indices rebalance. Our analysis focuses on major indices from MSCI, S&P, and FTSE Russell. We corroborate earlier research that the index effect is no longer significant for the S&P 500 and has weakened significantly for the Russell 1000 and Russell 2000. However, we find that the index effect is present in the global indices, particularly the MSCI World Small Cap and MSCI Emerging Markets indices. Security characteristics matter as well. The index effect is stronger for larger securities (relative to their index). We also find that the index effect appears to hold further ahead—for instance, a month before the index rebalance date. TOPICS: Mutual fund performance, passive strategies, exchange-traded funds and applications Key Findings • The index effect is an important phenomenon that needs to be monitored, particularly by index managers. • The index effect varies greatly across indices; it is most present in global indices, particularly those covering small cap and Emerging Markets. • The potential value add is even higher if one can accurately predict and trade index changes ahead of the announcement.