How to Trade S&P 500 Index Replacements
individualinvestor.com
Research Analyst: Bob Hirschfeld (08/17/00)
We know that when companies are added to the S&P 500 their stocks typically pop. But does the upside stop there or
does further good news usually follow?
In ``Games Traders Play,'' Wing Chow, head of Quantitative Analysis at Bear Stearns, analyzed the trading
performance for the last two years of stocks added to the S&P 500, the key index for benchmarking the performance of
portfolio managers.
Chow says the trading community has been ``gaming,''or trading on the news, all index additions. That creates increasing
volatility, though it's also producing a variety of trading patterns. According to Chow, stock performance after
inclusion largely relates to the origin of the included stocks, and depends on whether stocks named to the S&P 500 were
exchange-listed, or Nasdaq-listed, and whether shares previously belonged to the Mid-cap or Small-cap S&P indices.
Over the past two years, 98 stocks were added to the S&P 500. Chow breaks those down into four groupings:
Nasdaq-listed, with no prior S&P affiliation, or QX (9 stocks) Nasdaq-listed with prior S&P affiliation, or QI (29
stocks) Exchange-listed, without affiliation, or EX (18 stocks) Exchange-listed, with S&P affiliation, or EI (42 stocks).
Chow analyzed stock performance over a variety of periods, including from the inclusion announcement to the next
day's open, the open to inclusion-date-close, and the inclusion-date-close to 20 days later.
After being named to the S&P 500, all stocks, Chow notes, ``start hot.'' The average stock registers a 7.1% gain by next
day open after the announcement. Nasdaq stocks perform better than exchange stocks, with QX stocks performing
best, with an 11.3% return, and QI stocks performing next best, returning 8%.
QX and QI stocks do well after news of the S&P 500 index inclusion is announced, because for the six months prior to
inclusion, both groups of Nasdaq stocks typically outperform the index itself, Chow says. Because QX stocks were
not previously in any index, and thereby were more closely held, all things being equal, the relative inelasticity of QX
shares results in a greater rise, which further reduces the shares available.
From the next day open, after the announcement, until the inclusion date, QX stocks again perform best, outperforming
the S&P 500 index by 14%, followed by EX stocks, which outperform by 4%. According to Chow, stocks with prior
index affiliations do worse, given that transfers between indices increase supply sufficiently to dampen price gains. And
QX and EX stocks outperform, since they are fresh to the indices.
The inclusion date is the focus for many traders. Partly due to the use of market-on-close orders and average price
orders, traders tend to push prices higher the day of inclusion. That handicaps the indexes, which automatically get the
closing price on newly included stocks, and therefore ``suffer from the artificial price run-up'' writes Chow. The result
is one that likely delights managers whose performance is benchmarked against the index, as their job is then made the
easier.
That short-term inclusion day pop is followed ``almost certainly'' by a drop during the following days, due to
``short-term demand exhaustion.'' According to Chow, 60% of all stocks fall the day following inclusion.
The QX group is again the group with the highest volatility around the inclusion date. QX stocks on average gain 4.5%
the day before inclusion, a further 5.9% on the day of inclusion, then drop a total of 5.35% during the two days after
inclusion.
None of the other groups display the run-up-and-down pattern in so volatile a fashion. EX stocks are second-most
volatile, gaining 2% the day before inclusion, and 0.9% on the day of inclusion, with QI and EI stocks gaining less than
2% for the two days combined, and all groups losing money over the following two days.
Over the following twenty days, QX stocks, once again, are the stocks to own, as they continue to gain 1.4%. In
contrast, QI stocks gain a mere 0.9%, while EX and EI stocks lose 7.8%, and 4.1%, respectively.
As Chow suggests, after the date of inclusion in the S&P, it still makes sense to play the Nasdaq issues singled out for
``500'' status, though it's wise to wait at least twenty days on exchange-traded stocks.
Chow suggests ``indexers'' should buy half their position after the inclusion announcement in order to benefit from the
likely price run before addition. The best return, Chow notes, will very likely come from Nasdaq stocks not previously
index-listed, or QX stocks, though QIs continue to outperform too.
The second half of the position should be bought around the official addition or inclusion date, if the purchase is for
either group of Nasdaq stocks; for exchange-listed stocks, it's better to buy index additions after 20 days.
The pattern is fairly clear: Nasdaq stocks added to the S&P 500 tend to make traders money, even if bought after they
open following the inclusion announcement and, later, after inclusion. Chow says the outperformance of these stocks is
due to basic economic dynamics involving increasing demand and decreasing supply.
Bottom Line:
For traders, QX stocks are most likely to produce outsized returns. Not surprisingly, this group contains such growth
stock heroes as Yahoo (NASDAQ: YHOO - news), Broadcom (NASDAQ: BRCM - news), and JDS Uniphase
(NASDAQ: JDSU - news) And if trading patterns hold, short-sellers should mark their calendar for the inclusion dates
of exchange-listed stocks, which tend to decline over the 20-day period after being listed in the 500 index. Happy
trading!
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