An index is a basket of stocks designed to track and measure the performance of the market or a specific segment of it. There are dozens of domestic and international stock indices. Most are rebalanced periodically. Rebalancing involves replacing stocks that no longer meet an index’s inclusion criteria with new stocks that have become more representative since the previous rebalancing. This rebalancing can generate short-term spikes in the trading volume of the stocks being deleted and added and impact their prices, but the long-term effects are less clear.
Index Fund Buying
Many mutual funds and exchange-traded funds (ETFs) are based on various stock indices. When an index is rebalanced, the funds must sell the deleted stocks and buy the added ones in their portfolios. Fund buying often causes short-term volume and price spikes in the newly-added stocks. After the flurry of buying activity generated by index rebalancing, the stocks go back to trading based on their fundamentals. However, investor inflows into mutual funds and ETFs can push up the prices of all stocks in an index, in the same way that investor outflows can push them down.
An index may announce changes to its composition ahead of time. For example: On the 15th of the month an index publishes stock deletions and additions effective on the 1st of the following month. Index funds cannot make any changes to their portfolios until the index is officially changed, but speculators may start buying the new additions right away, reasoning that the funds will have to buy them later at any price. Speculator front running can cause the prices of stocks being added to increase prior to the official rebalancing date.
When the price of a small, obscure stock spikes on high volume when the stock is added to an index, the stock’s visibility increases: investors and traders may notice it for the first time and show interest. If they like what they see, they may start buying, further contributing to the stock’s price advance. However, as large as the stock universe is, there are no unresearched corners. If a stock hasn’t been discovered on its own merits, mere inclusion in an index is not likely to have a long-lasting impact. One exception could be a stock in a strong technical position that could advance for a while longer largely due to its chart pattern, which attracts momentum traders.
Inclusion by Default
Some large indices comprised of thousands of stocks, most of which are small and low-priced, may add stocks by default, simply because other stocks in the index have been delisted or bought out, or have declined below the minimal inclusion criteria and must be removed. Inclusion in an index can support the prices of such stocks, but is not likely to provide a boost.
- Creatas Images/Creatas/Getty Images