What drives the S&P 500 inclusion effect? An analytical survey.

We present an analytical survey of the explanations--price pressure, downward-sloping demand curves, improved liquidity, improved operating performance, and increased investor awareness--for the increase in stock value associated with inclusion in the S&P 500 Index. We find that increased investor awareness is the primary factor behind the cross-section of abnormal announcement returns. We also find some evidence of temporary price pressure around the inclusion date. We find no evidence that long-run downward-sloping demand curves for stocks, anticipated improvements in operating performance, or increased liquidity are related to the cross-section of announcement or inclusion returns.

On average, when stocks are added to the Standard and Poor's 500 Index, they earn positive abnormal returns on both the announcement date and the date they are actually included. In an early study of this phenomenon, Shleifer (1986) presents evidence that stocks that are included in the S&P 500 Index (the "Index") between 1976 and 1983 increase in value by nearly 3%. He argues that inclusion in the Index is an information-free event, and this value increase reflects a rightward shift of the downward-sloping demand curve due to demand from index tracking funds.

In this article, we examine S&P 500 Index inclusion effects by conducting an analytical survey of the explanations for this phenomenon: price pressure, downward-sloping demand curves, improved liquidity, improved operating performance, and increased investor awareness. We state each hypothesis in turn, and then compare them with each other.

Although our univariate findings support the results of previous work, our multivariate tests indicate that the investor awareness hypothesis is the primary explanation for the observed cross-section of announcement day price effects. We also find evidence of short-run price pressure in the pattern of post-inclusion day returns. In our multivariate tests, we find no evidence that proxies for long-run downward-sloping demand curves or anticipated improvements in operating performance or liquidity are related to the cross-section of abnormal returns associated with inclusion in the Index.

The article proceeds as follows: in Section I we provide institutional details on Index additions and document the abnormal returns with this event. In Section II we discuss each of the competing hypotheses and present univariate evidence for the particular hypothesis in our own data set. In Section III we present the results of the competition among the theories. We discuss our findings in Section IV and conclude in Section V.

I. The S&P 500 Index Effect

Before we examine the competing hypotheses that seek to explain the S&P 500 Index inclusion effect, we briefly discuss the institutional details regarding Index changes and then document price effects associated with inclusion.