Research Review | 16 October 2020 | Index Investing

Does Joining the S&P 500 Index Hurt Firms?
Benjamin Bennett (Tulane University), et al.
July 20, 2020
We investigate the impact on firms of joining the S&P 500 index from 1997 to 2017. We find that the positive announcement effect on the stock price of index inclusion has disappeared and the long-run impact of index inclusion has become negative. Inclusion worsens stock price informativeness and some aspects of governance. Compensation, investment, and financial policies change with index inclusion. For instance, payout policies of firms joining the index become more similar to the policies of their index peers. ROA falls following inclusion. There is no evidence of an impact of inclusion on competition.

Passive Investing: Luck or Patience?
Terry D. Nixon (Miami University)
July 2020
Passive investing over relatively long time-periods is a strategy followed by many individuals. In this paper, empirical evidence is presented beginning January 1950 that demonstrates that the success of this strategy is dependent not only on the length of the investment horizon, but also by the date of the initial investment. 10, 20, and 30-year periods are examined for both a lump sum initial investment and then for a monthly annuity investment. Longer horizons are shown to decrease the chance of an overall loss on a portfolio. However, different initial investment dates result in a wide range of ending portfolio values.

Dynamic Indexing and Allocation: Do they Dominate Simple Static Indexing?
Joseph E. McCarthy and Edward Tower (Duke University)
September 13, 2020
Andrew Lo in his book, Adaptive Markets, advocates an investment product that he names a “dynamic index.” He has facilitated the operation of a variant of this dynamic indexation, “dynamic allocation,” by founding a company, AlphaSimplex. Another dynamic investment is GMO’s Benchmark Free Allocation fund. We assess the role for dynamic investing with the AlphaSimplex funds and the GMO fund. The dynamic funds have higher expense ratios and turnover than static index funds do. Do the strategies of these funds add value, and if so is dynamic investing magical enough to overcome these hurdles? Do dynamic investments dominate a simple portfolio of static index funds with similar style rebalanced regularly whether risk adjusted or not and with or without differential expenses stripped away? We also clarify the interpretation of the Fama-French multi-factor models, generalize them, and discover the equivalence between the Fama-French and Sharpe (1992) approaches to mutual fund assessment. On average AphaSimplex funds underreturn portfolios of Vanguard index funds with the same style by 2.54 % age points per year. Some of that is because of expense ratios. Gross of expense ratios the average underreturn is 1.51 % age points/year.

The Shift from Active to Passive Investing: Risks to Financial Stability?
Kenechukwu Anadu (Federal Reserve Bank of Boston), et al.
May 15, 2020
The past couple of decades have seen a significant shift from active to passive investment strategies. We examine how this shift affects financial stability through its impacts on: (i) funds’ liquidity and redemption risks, (ii) asset-market volatility, (iii) asset-management industry concentration, and (iv) comovement of asset returns and liquidity. Overall, the shift appears to be increasing some risks and reducing others. Some passive strategies amplify market volatility, and the shift has increased industry concentration, but it has diminished some liquidity and redemption risks. Finally, evidence is mixed on the links between indexing and comovement of asset returns and liquidity.

Negative Returns on Addition to S&P 500 Index and Positive Returns on Deletion? New Evidence on Attractiveness of S&P 500 vs. S&P 400 Indexes
Anand M. Vijh and Jiawei (Brooke) Wang (University of Iowa)
August 17, 2020
In recent years, the majority of additions to and deletions from the S&P 500 index have been stocks that were previously or subsequently included in the S&P 400 index. The announcement returns of these changes have been the opposite of what has been documented for all S&P 500 additions and deletions in an extensive literature. During 2016-2019, such ‘upward additions’ to the S&P 500 index resulted in an average announcement excess return of -2.31% over a three-day period while ‘downward deletions’ resulted in an excess return of +1.21%. We explain these new results by the increasing ownership of S&P 400 stocks by institutional investors, the majority of whom are active fund managers. Our results thus show the increasing benefits of being included in the mid-cap S&P 400 index relative to being included in the large-cap S&P 500 index.

Proactive Indexing: Index Funds and IPOs
Jennifer Bender (State Street Global Advisors), et al.
June 2, 2020
While there is a vast amount of research on IPOs, little research has been done from the point of view of index funds and the excess return opportunity from buying IPOs before the index inclusion date. In this paper, we analyse U.S. listed IPOs, between 2010 and 2018, which were added to the Russell 1000 and the Russell 2000 indices. We conclude that index funds could have generated excess returns by buying IPOs prior to their inclusion in indices. However, the potential for excess returns differs depending on the index involved, the timing of the purchase, the relative size (market capitalization) of the IPO and its sector. Further we examine the risk incurred by index funds by buying IPOs early since it is not clear in advance which IPOs will eventually be included in an index. We conclude that for Russell 1000 index funds, IPOs with a larger market capitalization have a higher probability of being included in that index, but commensurately lower excess return and vice versa for IPOs with comparatively lower market capitalization. To harvest the potential excess returns, we develop a risk/return framework which could guide index portfolio managers in timing and sizing their IPO trades prior to their inclusion in indices.

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