The Shrinking Index Effect: A Global Perspective

Abstract

The index effect, or the excess returns of a stock added to a leading index, is one of the most researched pricing anomalies in finance.

Is the index effect shrinking? To answer this question, we study the index effect for headline indices of five of the biggest equity markets in the world: U.S. (S&P 500), Canada (S&P/TSX 60), Japan (Nikkei 225), U.K. (FTSE 100) and the Germany (DAX 30).

We find that excess returns for index additions have diminished over the past five years. The median excess return of S&P 500 additions was 3.8% for the past five years, compared to 6.0% for the five years prior. The declining pattern is also observed in Nikkei 225, S&P/TSX 60 and DAX 30, but not the FTSE 100.

The diminishing index effects may be attributed to several factors: First, the index effect has fallen victim to its own popularity. As more arbitrageurs have come in to the market, arbitrage profits have reduced. Second, changes in market structure and trading patterns of index funds have dented the index effect.

The index effect may never vanish completely. But its days as a profitable trading strategy may be numbered. Alternative index-related profit opportunities involve trading index changes in the options market or trading index share changes.

Keywords: index effect

JEL Classification: G30