Index changes (FTSE indices) – paper review

Every quarter the constituents of the FTSE 100 Index are reviewed, some companies may be removed to be replaced by others. An effect has been observed whereby companies joining the FTSE 100 Index experience a positive and permanent impact on their share prices.

This article presents a brief review and listing of academic papers on changes made to FTSE indices.


Traders are interested in changes to equity indices due to the potential arbitrage profits; but academics have a wider interest because for them changes to indices act as something like a laboratory for testing theories of stock market efficiency and behavioural finance. Briefly, when a stock joins (or leaves) an index, nothing changes to the company itself and so (in an efficient market) there should be no change to the share price. Academics therefore get excited (the term is used here relatively loosely) when this is not the case.

Comovement

Kougoulis and Coakley (2004) found that shares joining the FTSE 100 Index experienced an increase in comovement (price movement correlation with other shares); shares leaving the index experienced the opposite effect. Mase (2008) supported the previous findings and in addition found that increases in comovement had become larger in recent years, and that the overall increase in comovement was due to new additions to the index rather than previous FTSE 100 constituents re-joining the index.

Price pressures

Another favourite of academics. If a share price moves without new information is the move temporary (price pressure hypothesis) or permanent (imperfect substitutes hypothesis)? Mazouz and Saadouni (2007) found strong evidence for the price pressure hypothesis: prices increased (decreased) gradually starting before the index change announcement date of inclusion (exclusion) and then reversed completely in less than two weeks after the index change date. The existence of the temporary price changes (price pressure hypothesis) was also found by Opong and Antonios Siganos (2013) and Biktimirov and Li (2014). Interestingly, Mase (2007) comments that the temporary prices changes to shares joining/leaving the FTSE 100 Index is in contrast to the case for S&P 500 index changes where permanent price changes have been found.

Information efficiency

Daya and Mazouz and Freeman (2012) (and other papers) found that informational efficiency improved for stocks added to the FTSE 100, but did not diminish after deletion.

Now, onto the more useful topics.

Price changes

Gregoriou and Ioannidis (2006) found that price and trading volumes of newly listed firms increased. That confirms what we already knew or suspected. But, interestingly, they (and other papers here) attribute the cause to information efficiency: stocks with more available information increase investor awareness. However, Mase (2007) does say that investor awareness and monitoring due to index membership do not explain the price effects. But not mentioned here is the influence of index funds.

And, finally, the interesting stuff.

Anticipatory trading

Fernandes and Mergulhao (2011) found that a trading strategy based on addition/deletion probability estimates gave an average daily excess return of 11 basis points over the FTSE 100 index. Opong and Siganos (2013) found “significant net profitability” from an investment strategy based on firms on the FTSE reserved list. And a strategy based on the FTSE 100 quarterly revisions was profitable if CFDs were used and traders could deal within the bid/ask spread.


INDEX (of papers listed below)

[Papers listed in reverse date order; indicates major paper.]

  1. Asymmetric stock price and liquidity responses to changes in the FTSE SmallCap index [2014]
  2. Compositional changes in the FTSE 100 index from the standpoint of an arbitrageur [2013]
  3. Information efficiency changes following FTSE 100 index revisions [2012]
  4. Anticipatory Effects in the FTSE 100 Index Revisions [2011]
  5. Comovement in the FTSE 100 Index [2008]
  6. The Impact of Changes in the FTSE 100 Index [2007]
  7. The price effects of FTSE 100 index revision: what drives the long-term abnormal return reversal? [2007]
  8. New evidence on the price and liquidity effects of the FTSE 100 index revisions [2007]
  9. Investor awareness and the long-term impact of FTSE 100 index redefinitions [2006]
  10. Information costs and liquidity effects from changes in the FTSE 100 list [2006]
  11. Comovement and Changes to the FTSE 100 Index [2004]


Asymmetric stock price and liquidity responses to changes in the FTSE SmallCap index
Authors [Year]: Ernest N. Biktimirov and Boya Li [2014]
Journal [Citations]: Review of Quantitative Finance and Accounting, 42(1), pp95-122
Abstract: We examine market reactions to changes in the FTSE SmallCap index membership, which are determined quarterly based on market capitalization and are free of information effects. Our main results are asymmetric price and liquidity responses between the firms that are shifted between FTSE indexes and the firms that are new to FTSE indexes. Firms promoted from a smaller-cap to a larger-cap FTSE index experience a permanent increase in stock price accompanied by improvements in liquidity. Similarly, firms demoted from a larger-cap to a smaller-cap FTSE index experience a permanent decrease in stock price accompanied by declines in liquidity. In contrast, firms added to the FTSE SmallCap index that were not previously in FTSE indexes show a transitory price gain and declines in liquidity. The results support the liquidity and price pressure hypotheses.
Ref: AA704


Compositional changes in the FTSE 100 index from the standpoint of an arbitrageur
Authors [Year]: Kwaku Opong1 and Antonios Siganos [2013]
Journal [Citations]: Journal of Asset Management, 2013 (14), pp120–132 [2]
Abstract: We explore the profitability of a strategy that is based on the quarterly addition/deletion revisions of the FTSE 100 index and of a strategy that is based on the irregular additions of reserve companies on the list of firms to be included in the FTSE 100. We estimate the transaction cost based on whether investors buy/sell physical shares and contracts for difference (CFDs). We find that investors can enjoy significant net profitability from an investment strategy based on firms on the FTSE reserved list. An investment strategy based on the quarterly revisions of the FTSE 100 is profitable as long as traders buy/sell CFDs and have significant negotiation power to trade within the bid and ask spread. This study supports the price pressure and attention grabbing news hypotheses. Our results also show evidence against stock market efficiency.
Ref: AA703


Information efficiency changes following FTSE 100 index revisions
Authors [Year]: Wael Daya and Khelifa Mazouz and Mark Freeman [2012]
Journal [Citations]: Journal of International Financial Markets, Institutions and Money, 22(4), pp1054–1069
Abstract: This study examines the impact of FTSE 100 index revisions on the informational efficiency of the underlying stocks. Our study spans the 1986–2009 period. We estimate the speed of price adjustment and price inefficiency from the partial adjustment with noise model of Amihud and Mendelson (1987). We report a significant improvement (no change) in the informational efficiency of the stocks added to (deleted from) the FTSE 100 index. The asymmetric effect of additions and deletions on informational efficiency can be attributed, at least partly, to certain aspects of liquidity and other fundamental characteristics, which improve following additions but do not diminish after deletions. Cross-sectional analysis also indicates that stocks with low pre-addition market quality benefit more from joining the index.
Ref: AA707


Anticipatory Effects in the FTSE 100 Index Revisions
Authors [Year]: Marcelo Fernandes and Joao Mergulhao [2011]
Journal [Citations]: Midwest Finance Association 2012 Annual Meetings Paper ,
Abstract: This paper examines the price impact of trading due to expected changes in the FTSE 100 index composition. We focus on the latter index because it employs publicly-known objective criteria to determine membership and hence it provides a natural context to investigate anticipatory trading effects. We propose a panel-regression event study that backs out these anticipatory effects by looking at the price impact of the ex-ante probability of changing index membership status. Our findings reveal that anticipative trading explains about 40\% and 23\% of the cumulative abnormal returns of additions and deletions, respectively. We confirm these in-sample results out of sample by tracking the performance of a trading strategy that relies on the addition/deletion probability estimates. The performance is indeed very promising in that it entails an average daily excess return of 11 basis points over the FTSE 100 index.
Ref: AA672


Comovement in the FTSE 100 Index
Authors [Year]: Bryan Mase [2008]
Journal [Citations]: Applied Financial Economics Letters, 4(1), pp9-12 [9]
Abstract: This article extends recent research (Barberis et al., 2005) on the impact of index changes on stock comovement. Stocks that are added to the FTSE 100 comove more closely with the FTSE 100, whilst the reverse is found in stocks deleted from the FTSE 100. Consistent with previous research, these changes appear to have become larger over more recent years. As a result of the method by which changes are made to the FTSE 100, this article is able to distinguish between additions that are new firms and additions that have previously been constituents. There is a significant difference between these two sets of firms, both in terms of the change in comovement and the extent of their comovement after addition to the FTSE 100. Specifically, it is the change in comovement among firms that are new to the FTSE 100 that drives much of the overall increase in comovement among additions. This result implies that the change in comovement cannot be explained solely by the behavioural finance view of comovement and the associated impact of category or habitat traders.
Ref: AA673


The Impact of Changes in the FTSE 100 Index
Authors [Year]: Bryan Mase [2007]
Journal [Citations]: Financial Review, 42(3), pp461–484 [25]
Abstract: This paper investigates FTSE 100 index membership changes, which are determined quarterly by market capitalization and should have no information content. Return reversal around index additions and deletions suggests that buying (selling) pressure moves prices temporarily away from equilibrium, consistent with short-term downward sloping demand curves. In contrast to widely reported results for the S&P 500, there is no evidence of permanent price effects. Further results suggest that investor awareness and monitoring due to index membership do not explain the price effects. There is statistically significant anticipatory trading in stocks that just fail to be promoted to the FTSE 100.
Ref: AA670


The price effects of FTSE 100 index revision: what drives the long-term abnormal return reversal?
Authors [Year]: Khelifa Mazouz and Brahim Saadouni [2007]
Journal [Citations]: Applied Financial Economics, 17(6), pp501-510 [9]
Abstract: We examine short- and the long-term price effect associated with the FTSE 100 index revisions. We control for both heteroskedastic nature of the residual and the change, between the estimation and the test period, in the beta coefficient of the standard market model. Our findings reveal no relationship between the long-term price reversals and the change in the discount rate, as approximated by the beta coefficient of the market model. Overall, we provide strong evidence in favour of the price pressure hypothesis, where the price increase (decrease) gradually starting before the announcement an inclusion (exclusion) and reverses completely in less than two weeks after the index revision date.
Ref: AA674


New evidence on the price and liquidity effects of the FTSE 100 index revisions
Authors [Year]: Khelifa Mazouz and Bharim Saadouni [2007]
Journal [Citations]: International Review of Financial Analysis, 16(3), pp223–241 [4]
Abstract: We study the price and liquidity effects following the FTSE 100 index revisions. We employ the standard GARCH(1,1) model to allow the residual variance of the single index model (SIM) to vary systematically over time and use a Kalman filter approach to model SIM coefficients as a random walk process. We show that the observed price effect depends on the abnormal return estimation methods. Specifically, the OLS-based abnormal returns indicate that the price effect associated with the index revision is temporary, whereas both SIM with random coefficients and GARCH(1,1) model suggest that both additions and deletions experience permanent price change. Added (removed) stocks exhibit permanent (temporary) change in trading volume and bid-ask spread. The analysis of the spread components suggests that the permanent change associated with additions is a result of non-information-related liquidity. We interpret the permanent price effect of additions and deletions combined with the permanent (temporary) shift in liquidity of added (removed) stocks as evidence in favour of the imperfect substitution hypothesis with some non-information-related liquidity effects in the case of additions.
Ref: AA753


Investor awareness and the long-term impact of FTSE 100 index redefinitions
Authors [Year]: Bryan Mase [2006]
Journal [Citations]: Applied Financial Economics, 16(15), pp1113-1118 [5]
Abstract: This study finds an asymmetric long-run abnormal return performance following stocks’ inclusion in or deletion from the FTSE 100 Index. This asymmetry suggests that investors’ awareness of stocks is influenced by index changes. These results extend those documented by Chen et al . (2004) for the S&P 500.
Ref: AA684


Information costs and liquidity effects from changes in the FTSE 100 list
Authors [Year]: Andros Gregoriou and Christos Ioannidis [2006]
Journal [Citations]: The European Journal of Finance, 12(4), pp347-360 [11]
Abstract: In this paper we examine the stock price effect of changes in the composition of the FTSE 100 over the time period of 1984–2001. Like the S&P 500 listing studies, we find that the price and trading volume of newly listed firms increases. The evidence is consistent with the information cost/liquidity explanation. This is because investors hold stocks with more available information, implying that they have lower trading costs. This explains the increase in the stock price and trading volume of newly listed stocks to the FTSE 100 List. We find the reverse effect for the deletions from the FTSE 100.
Ref: AA752


Comovement and Changes to the FTSE 100 Index
Authors [Year]: Periklis Kougoulis and Jerry Coakley [2004]
Journal [Citations]: EFMA 2004 Basel Meetings Paper, [8]
Abstract: We employ the Barberis, Shleifer and Wurgler (2004) methodology to investigate the impact of changes to the FTSE 100 index on return comovement over the 1992-2002 period. For FTSE stock inclusions the average increase in the beta coefficient is 0.38 in univariate regressions for weekly returns and 0.60 in bivariate regressions that control for the return on non-FTSE stocks. Stocks deleted from the index display the opposite pattern post exit. The results are robust to a number of factors including size, industry and non-trading effects. They are difficult to explain within a classical framework but complement those found for the US and Japan in supporting behavioral finance views of comovement.
Ref: AA671


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