A Market Edge: Index Additions & Deletions

The most sustainable edges, that may enable an investor to beat the market, can be found in its structure – instances where market participants are predictably forced to take action. One such anomaly is the addition and deletion of individual stocks to a major market index. Predictable flows of money into and out of specific stocks around a certain date occur as ETFs and other index oriented investors are forced to add the new candidates to their portfolio and sell the ones that are leaving.

This creates a significant temporary price distortion around a specific date.

Large indices (e.g. the S&P 500) also function much like a long-term trend following system: equities that are added in aggregate display strong growth and good performance to be considered a candidate for addition. As the reverse is true for stocks leaving a major index, market cap weighted indices add stocks that are rich in valuation and delete equities traded at a discount.

This structural element can be used to create a value-based, systematic investment strategy that benefits from mean-reversion – historically this has led to a distinct advantage over investing passively in the index.

Mean reversion

Stocks that are included in an index win big before they’re added while discretionary deletions (not caused by mergers, bankruptcies, etc.) lose significantly before they’re dropped. This pattern reverses the year after an index change.

The key data I use to build my strategy is from the Research Affiliates 2017 article “Buy High and Sell Low with Index Funds!” accumulated in the following chart:

Index additions outperform significantly before an index rebalance after which deletions take over and begin to lead to quickly make up for previous weakness starting about one week after they are dropped.

“After the rebalancing date, this situation reverses, and the deletions beat the additions by over 20%, with the lion’s share of the difference coming from the deletions.” Research Affiliates

The 2004 paper “The Price Response to S&P 500 Index Additions and Deletions: Evidence of Asymmetry and a New Explanation“ supports this data and finds a significant short-term mean reversion effect:

“The negative effect of deletions (-14% on average) disappears completely 60 days after the effective date.”

Speculating on a possible index addition

The most striking outperformance of an individual stock unsurprisingly happens well in advance of an announced index addition – around three months before the announcement this development is already largely priced in. Index additions beat the market, on average, by 30% in the year prior to the rebalancing date.

Speculating on this effect is difficult as it involves predicting an unknown which cannot be done systematically. It is always wrought with the danger of being wrong as the recent TESLA example showed:

TESLA drops it is not included in the S&P 500 as expected

The effect for stocks that are deleted from the index on the other hand can be systematically used as one can work with certain, known information.

Building a systematic investment approach around the anomaly

Getting the data to construct two possible portfolios
The key element of a systematic strategy is a current list of stocks that are discretionarily deleted by Standard and Poor’s from the S&P 500 and not dropped because of mergers, bankruptcies or other forms of involuntary deletions.

These stocks can then be bought one week after they left the index to form a portfolio to be held for one year.

The change in S&P 500 index constituents takes place with a quarterly rebalance (end of March, July, September & December) and is announced via press release on Standard and Poor’s website 2- 3 weeks before the effective change takes place. That means the portfolio can easily be adjusted 4 times a year by selling positions that were held for a year and adding the new announcements in equal weight – a 25% quarterly turnover.

To capitalize on the short-term reversal of the negative price distortion caused by the deletion, it would also be possible to build a more concentrated portfolio: one week after the deletion is effective we buy the deleted stocks and sell them 2 months later, completely turning around the entire portfolio once each quarter.

This looks like sustainable outperformance that can be captured by an investor with just a small amount of effort.

Good luck with your investments & thank you for reading!

David