Since stock index funds buy the same stocks as the index, won't their prices become artificially inflated?
May 7th, 2010
My understanding of the DOW or S&P500 index funds is that if GE represents say 1% of the S&P500, it will represent 1% of the value of the S&P500 index funds.
Since many people invest in these index funds to represent the market, won’t any company in the index be artificially inflated in price due to heightened demand?
Another way to ask this is: Do companies that join an index experience a bump in share price & do companies that leave experience a drop within a short amount of time?
Thanks!
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"Another way to ask this is: Do companies that join an index experience a bump in share price & do companies that leave experience a drop within a short amount of tim"
Yes, there’s a well known "index-effect". There’s even a bit of a game of trying to guess which companies will be added to the index.
Companies are deleted from the index usually because of acquisition, or bankruptcy. Very rarely are they "just deleted", so a "deletion effect" is less common.
Believe it or not, this so-called "index effect" has been the subject of considerable academic research. The following article claims that the effect is real, but temporary. There might be some short term trading opportunities based on the index effect. It might not be a bad idea to buy a stock shortly before it is added to the S&P 500 and sell it shortly afterwards.
If the company is part of the Index, and people own Index funds then they are choosing to own part of that company as well.
So it kind of comes down to what you mean by ‘Artificially inflated’
There’s an increase in demand, but it’s a Real and Long Term Increase in Demand.
So would you consider that artificial? The price may go up a bit, but the stock and company now has more visability, it will have more analyst coverage, more volume, more price support…Even though the technically value of the company didn’t increase, the Stock is now more valuable because it comes with more perks.
Most of the time a company joins an Index it does get a bump, however you can’t bank on it.
One of the best examples ever was JDSU. It was added to an Index which was expected to add 96 Million shares of Demand to the stock the next day, typically raising the price.
Early in the morning it started to pop up as expected, but didn’t seem to have any legs..then slowly dropped, then quickly dropped.
A Japanese company who owned 142Million shares decided to use the bump in demand to mask the selling off of their entire stake in it.
Also remember the market anticipates things a lot ahead of time, so the actual adding to the index is softened because people bought or sold it before that, anticipating it being added. The market generally knows when a stock will be added to something. For instance many people assume MasterCard will be in the S&P 500 after its IPO waiting period is over, so will buy it on speculation of that.
Similarly, No one was suprised when eastman Kodak was removed from the Dow Jones Index so it softens that blow