Comovement after joining an index: spillovers of nonfundamental effects.(Author abstract)

This study considers the case of two overlapping categories in the context of recent category models. Specifically, we examine whether investor sentiment and market frictions specific to one category can affect the returns on assets belonging to the other category. With recent additions of several real estate investment trusts (REITs) into general stock market indices as a natural experiment, we find support for spillovers of such nonfundamental effects, as evidenced by the increased return correlation between REITs that remain outside the index and the index stocks. Further analysis reveals that market frictions play a greater role than investor sentiment.

**********

Over the past several years, a literature has developed suggesting that asset returns can comove more than their fundamentals alone would justify. Among others, Barberis and Shleifer (2003) and Barberis, Shleifer and Wurgler (2005) show that, when investors form asset categories and trade based on them, investor sentiment or market frictions associated with those categories can lead to excess return comovement among assets in the same category. In the context of their model, category-specific sentiment arises when investors focus on differences between categories but not on within-category distinctions; in the extreme, such sentiment can lead investors to focus on a single category. At the same time, category-specific market frictions can retard the diffusion of new information so that assets in different categories do not incorporate the new information at the same speed.

In this study, we consider the case of two overlapping categories. This case complements the original category model by shedding light on possible spillovers of nonfundamental effects (i.e., investor sentiment and/or market frictions) between categories. An understanding of such spillovers is crucial for analyzing markets in which asset categories are dynamic, and thus category overlaps are likely.

An overlap can arise when an asset (which we refer to as the common asset) joins a new category while maintaining its membership in its original category. In this formulation, investor sentiment and market frictions that are specific to one category can affect the returns on assets belonging to the other category. Specifically, investors in one category can expand their investment interest to the other category, resulting in greater comovement between the two categories. Investor sentiment can also trigger mispricing in one category and consequently invite pairs trading between the common asset and assets in the other category, effectively transmitting sentiment across categories and creating excess comovement. (1) From the market friction point of view, such weakening of distinctions between the two categories can make new information diffuse to both categories at more similar rates, again leading to greater comovement.

We test this spillover implication using the recent introduction of several real estate investment trusts (REITs) into the Standard and Poor's (S & P) general stock market indices (i.e., S & P500, S & P400 and S & P600 indices). This event has several features that allow for a clean test. First, both the REIT sector and the S & P market indices are well defined, so that it is straightforward to determine whether a certain stock is a member. As a result, an overlap between them and the scope of possible spillovers can be accurately identified. Second, because the S & P market indices are well diversified across industries and sectors, possible spillovers will be unidirectional, flowing from the index category to the REIT category. Third, the REIT sector and the S & P market indices each constitutes a category as defined in the original category models. In particular, the common investment classifications divide the investment universe into four broad asset categories consisting of cash, stocks, bonds and real estate. Thus, representing the most liquid vehicle for real estate investment, REITs are considered to be a single homogeneous investment class, even though the economic fundamentals of individual REITs differ somewhat (e.g., Chui, Titman and Wei 2003). (2) Finally, because the index additions are a recent event, we can utilize an uncontaminated pre-addition benchmark period during which no REITs were included in the index category, and thus no spillovers can possibly be present.

Our first set of results is easily summarized. We begin by confirming for REITs the prior general finding of an increase in the beta of stocks that are added to an index. (3) Interestingly, these index REITs show virtually no change in their beta with the portfolio of nonindex REITs (those that are never added to the index), suggesting that, after some REITs were introduced into the index, the nonindex REITs might have comoved more with the index category as well. It turns out that the beta of nonindex REITs with the S & P market indices indeed increases after some REITs were introduced. The magnitude of these beta increases is not trivial; the beta of nonindex REITs, as well as that of index REITs, almost doubles around the index addition event. (4,5)