The Index Inclusion Effect Isn't Cause for Concern

A version of this article previously appeared in the April 2022 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.

After U.S. markets closed on Friday, June 15, 2018, the S&P Index Committee announced that it would add Fleetcor Technologies FLT to the S&P 500. The next Monday—the first day investors could trade Fleetcor stock with this news in hand—the newly minted S&P 500 inductee leapt 6.45% as the broad market sunk. But Fleetcor’s run was short-lived. One week after it officially joined the S&P 500, the stock had retreated to a level near its pre-announcement price.

This arc is commonly called the index inclusion effect. It describes the tendency for a stock's price to spike on news that it will join a widely followed benchmark like the S&P 500, only to fizzle following the change. A flurry of activity from index funds, benchmark-beholden active managers, and opportunistic front-runners powers the index inclusion effect. Behemoths like SPDR S&P 500 ETF Trust SPY must purchase new inductees to ensure they accurately track their benchmark, and their heft can put upward pressure on these stocks’ prices.

Some critics of indexing cite the index inclusion effect as a deficiency, one that saddles index fund investors with nonobvious, implicit costs. However, recent research indicates that the effect has disappeared in the past decade.

Losing Steam

While Fleetcor’s parabola in June 2018 is a textbook example of the index inclusion effect, research shows that this effect has weakened over the past 25 years. Standard & Poor’s compared the median excess returns of new S&P 500 additions in the period between the announcement date (when S&P signaled that a stock would join the index) and the rebalance date (when the addition took effect) over three distinct time periods: 1995-99, 2000-10, and 2011-20. The results, illustrated in Exhibit 1, show that what was once a pronounced pattern has not only softened, but disappeared entirely.

New index additions’ post-inclusion tumbles generally vanished, too. Indeed, the up-and-down trajectory that was once the fingerprint of the index inclusion effect now resembles a flat line that runs from announcement date through the weeks following inclusion in the S&P 500.

The apparent demise of the index inclusion effect is counterintuitive. If index funds’ heft and the actions of other market participants pressure new index additions’ stock prices, passive investing’s mainstream acceptance should accentuate the effect. Over 10 times as much money is indexed to the S&P 500 today than 20 years ago, so what gives?

While there is no certain answer, improved market liquidity can help explain the index effect’s decline. Consider that many new S&P 500 additions graduate from smaller S&P benchmarks like the S&P MidCap 400 or S&P SmallCap 600 indexes. When S&P 500 trackers buy stocks that graduate from their smaller brethren, funds that track those indexes must sell them simultaneously, helping offset the upward pricing pressure. Far more wealth is attached to the S&P 500 than its mid- and small-cap counterparts, but mid- and small-cap index funds have grown at a faster rate over the past two decades. The amount of money indexed to the S&P MidCap 400 and S&P SmallCap 600 indexes increased about 12-fold and 35-fold, respectively, over the 20 years through 2021.

Outside the Lines

Not all S&P 500 constituents arrive in the index by graduating from the ranks of mid- and small-cap stocks. Some companies long had the size to earn a spot in the benchmark but were admitted only after meeting its float, liquidity, or profitability requirements. When these outsiders make the cut, funds that track the S&P 500 do not benefit from index-tracking counterparties that are forced to simultaneously sell the stocks. Indeed, S&P found that unlike stocks that graduated from the S&P MidCap 400 or S&P SmallCap 600 indexes, outside additions have still exhibited the index inclusion effect over the past decade.

Tesla TSLA is the most salient example of an outside addition in recent memory. After it met the S&P 500’s earnings requirement in late 2020, it cannonballed into the portfolio. Upon inclusion, Tesla had a 1.68% weight in the index and ranked as its fifth-largest constituent. In the month between Tesla’s announcement date and its official entry to the S&P 500, its share price soared over 70%—which was about 28 times the broad market’s return over this span—as canny traders front-ran index funds’ imminent Tesla purchases and S&P 500 trackers dutifully piled in to replicate their benchmarks on inclusion day. Apartment Investment & Management AIV, which was pulled from the index to clear room for the flashy newcomer, slid 0.69% over the same span.

True to the tune of the index inclusion effect, the two stocks’ fortunes reversed immediately after the S&P 500 update. Tesla dropped 7.86% over the two days after its S&P 500 debut, while Apartment Investment & Management leapt 12.39%. Apartment Investment & Management outperformed its replacement by over 28 percentage points in the three months that followed the rebalance, and by over 70 percentage points during the six months following Tesla’s addition. Is this trade—buy the expelled and short the outsider replacement—a sensible tack for investors looking to cash in on the index effect?

Putting It into Practice

Evidence that the index effect lives on in those cases where stocks enter the S&P 500 from outside of the broader S&P 1500 composite index doesn’t mean investors can capitalize on this phenomenon with ease. Stocks ousted from the S&P 500 are not guaranteed to rebound. For example, Foot Locker FL declined 21.9% from its August 2019 removal through March 2022, trailing the S&P 500 by more than 85 percentage points during that period.

It may be difficult for investors to accurately time their trades when aiming to profit from the index effect. Tesla’s and Apartment Investment & Management’s shares showed the impact of the index inclusion effect within a couple of days, but that won’t always be the case.

Exhibit 2 explores the post-rebalance performance of the next five largest S&P additions of the past 20 years, all of which came from outside the S&P universe. Meta Platforms’ META inaugural year in the S&P 500 vouches for a short-term trade, as it warmed up to its new index after an ice-cold start. Meta trailed the S&P 500 by 1.57 percentage points in the week after its addition but outpaced the benchmark by nearly 30 percentage points over its first 12 months in the index. A short-term mindset would have bred unfavorable results when Berkshire Hathaway BRK.B came on board, however; it outperformed in its first week but finished its first full post-rebalance year 16 percentage points behind the S&P 500.

Deflect the Effect

It doesn’t make sense for most investors to attempt to profit off the effect with tactical bets, but some index fund investors may loathe that their core stock funds buy stocks at suboptimal prices.

The best way to protect against the index inclusion effect is to purchase index funds that span entire markets rather than gluing together ones representing the large-cap, mid-cap, small-cap, and value-to-growth dimensions. The more seams there are in your portfolio of index funds, the more likely it is that the index inclusion effect might cause some of your returns to leak.

Vanguard Total Stock Market ETF VTI is a great example of such a seamless fund. The fund bought Tesla at the end of 2010 when its market cap was just $2.5 billion and reaped the rewards as it ballooned to $1.1 trillion at the end of March 2022. In the year following the announcement that Tesla would join the S&P 500, VTI squeezed 67 more basis points of return from the stock than Vanguard S&P 500 ETF VOO, which was forced to purchase it at a rich valuation.

Investors that want to stick to the top of the market may look to Vanguard Large-Cap ETF VV as a larger-minded option that is more wary of the index effect. This fund replicates the CRSP U.S. Large-Cap Index, which spreads its rebalance over five days to reduce the market-impact cost of trading. It won’t always buy at better prices than indexes that rebalance in one fell swoop, but it reduces the risk of one ill-timed rebalance cutting into returns.

Reality Check

Despite index funds’ increased popularity, the index inclusion effect has generally trended downward over the past 25 years. S&P 500 additions that immediately take a top spot in the index are more likely to exhibit the effect, but even those inclusions’ impact on fundholders’ bottom line tends to be negligible. Investors that are focused on eliminating the index inclusion effect can ease their concerns by buying broader funds. For most investors, any further action will likely bring more worry than reward.

[1] Preston, H., & Soe, A.M. 2021. "What Happened to the Index Effect? A Look at Three Decades of S&P 500 Adds and Drops." S&P Dow Jones Indices Research. https://www.spglobal.com/spdji/en/research/article/what-happened-to-the-index-effect-a-look-at-three-decades-of-sp-500-adds-and-drops.

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