Price Response to Factor Index Decompositions
Erasmus University – Rotterdam School of Management; Robeco Quantitative Strategies; Erasmus University Rotterdam (EUR) – Erasmus Research Institute of Management (ERIM)
Erasmus University Rotterdam (EUR), Rotterdam School of Management (RSM); Robeco Asset Management
October 3, 2016
Abnormal price reaction around S&P 500 index changes has been considered as strong evidence that long term demand for stocks is downward sloping. This notion, however, has recently lost popularity due to the evidence that new additions are accompanied with a contemporaneous change in future earnings expectations. In this study we show that factor index rebalancing is a true information free event. The cumulative abnormal return from announcement to effective day is 1.07% for new additions and -0.91% for new deletions and around two-thirds of this effect is permanent. We find a direct relationship between the magnitude of abnormal returns and the abnormal volume coming from index funds. The documented effect results in a direct loss to index fund investors of 16.5 bps per annum.
Price Response To Factor Index Decompositions – Introduction
Flat demand curve for stocks is a key assumption in modern finance theories such as the Capital Asset Pricing Model of Sharpe (1964) and Lintner (1965) and the Arbitrage Pricing Theory of Ross (1976). These concepts are based on the idea that stocks have perfect substitutes and risk is the only determinant driving stock prices. If there is no change in the perceived riskiness of a stock investors can trade large quantities with no significant price impact. In this paper, we document significant abnormal price movements around factor index additions and deletions and provide evidence in favor of download sloping demand curves.
As the lack of evidence for flat demand curves could cast doubts on these concepts a large body of literature is concentrated in this area. The general research framework is to identify stocks that exhibit supply shocks and examine their subsequent price reaction. A first stream of literature investigates price movements around large block sales and surprisingly document strong negative reactions (e.g. Scholes, 1972, Partch, 1985, Holthausen, Leftwich, and Mayers 1987). However, these events arguably suffer from information contamination. That is if the supply shock is caused by a flow of new information to the market then price movements are rational and reflect adjustments to their new fundamental values. Large block sales are often triggered by investors having new negative information about the stock. Later studies acknowledge this weakness and look for other ways to identify information-free events.
A large stream of literature on demand curves focuses on abnormal return patterns around S&P 500 index changes. It is motivated by the fact that, as Standard and Poor’s claims, this index contains no relevant information about stocks, meaning that additions and deletions are purely mechanical. As such, if markets are efficient and demand curves for stocks are flat, new additions to the index are not supposed to exhibit abnormally high returns. Harris and Gurel (1986), Shleifer (1986), Beneish and Whaley (1996), Chen, Noronha, and Singal (2004) all document the opposite – new additions are associated with high abnormal returns. These studies, however, disagree on the reason for the price movement. Harris and Gurel (1986) show that the effect is temporary driven by compensation for providing immediate liquidity. The remaining studies find permanent price increase consistent with long-term downward sloping demand curves, which casts serious doubt on the efficient markets hypothesis.
More recent studies question the premise that S&P 500 additions are information-free events. Denis, McConnell, Ovtchinnikov, and Yu (2003) show that newly added stocks significantly improve both their forecasted and realized earnings, suggesting that despite thought to be information-free, index additions do contain new information for stocks. Therefore, the documented abnormal inclusion returns are not evidence for downward sloping demand curves but, similar to large block sales, they reflect the mechanism of prices adjusting to their fundamental values. Some of the reasons mentioned to explain the improved fundamentals after inclusion in the S&P 500 are better monitoring by investors, higher reputation risk for firm managers causing them to put more efforts, or higher analyst coverage leading to higher information quality which lowers the risk premium related to information uncertainty demanded by investors.
In this paper we identify a unique and novel information-free event in the face of factor index additions and deletions. These type of indices are relatively new investment vehicles based on the insights of Fama and French (1992, 1993) that some market segments, such as high book-to-price or small capitalization stocks systematically outperform the market portfolio in the long run. This trend, also known as factor investing, quickly gains popularity in the financial industry and opens new possibilities for practitioners as well as academics.
Factor indices are characterized by two unique features. First, all stocks included in the index are already part of a broader “parent” index. As such, the critique that there is an improvement in fundamentals after including stocks in a “parent”, e.g. S&P 500, is ungrounded since all stocks of a sub-index are already part of the broad index. That is there is no increased analyst coverage, management motivation, or better monitoring just because a stock is moved from one segment of S&P 500 to another. Second, the construction of factor indices is purely mechanical as it is simply based on ranking stocks on characteristics such as book-to-price, past volatility, or return-on-equity. This information is public and available to market participants so using it to put a ‘label’ on a stock should have no consequences for future stock return.
The contributions of this paper can be summarized as follows. First, by using MSCI Minimum Volatility indices we show that factor index rebalancing is a true-information free event. Additions and deletions are not associated with significant increase in future earnings expectations. Second, we document positive (negative) and significant abnormal price reaction for newly added (deleted) stocks. The cumulative abnormal return from announcement to effective day is 1.07% (-0.91%) and around two-thirds of this effect is permanent. This evidence suggests that after a stock is added to a factor index there is a new supply-demand equilibrium achieved from a rightward shift of a downward sloping demand curve. Third, we find a direct relationship between the magnitude of abnormal returns and the abnormal volume coming from index funds. Finally, we estimate the cost of transparency for public factor indices to be 16.5 bps per annum which has important implication for the pricing of investment vehicles aiming to provide access to academically documented factor premiums.
The rest of the paper is organized as follows. Section II makes a detailed overview of the related literature and explanation hypotheses. Section III describes our data, index choice, and methodology. Section IV summarizes our main empirical findings. Section V presents a discussion and alternative explanation of the results. Section VI explains the practical implication of our study and Section VII concludes.
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