The market impact on shares entering or leaving JSE indices

Abstract

A company's entry into (or exit from) a major share index provides a special opportunity to examine price discovery. In an efficient market, we expect the demand curve to remain horizontal and to be unaffected by external events that do not communicate new information to the public, even if demand is affected. However, there is evidence that changes to index composition do impact the value of affected shares. This may be due to the price pressure generated by passively managed investment funds that simultaneously reconstitute their portfolios in order to remain aligned to the index they are tracking. This study investigates downward sloping demand curves, price pressure and other hypotheses which are related to changes in index composition on the Johannesburg Stock Exchange (JSE). We calculate abnormal returns using a control portfolio model for shares entering/exiting four major FTSE/JSE indices between 2002 and 2011. In the pre-event window, a long-term increasing trend was observed in the share prices of companies that are added to market cap weighted indices, beginning 70 trading days before the effective date. The opposite behaviour was true for index deletions, with some variation in the timing. In the post-event window the results show, to some extent, an asymmetric response to share returns; shares entering the index underperform thereafter, whereas those leaving the index outperform. Although these findings were not significant for all of the indices examined, they do support the Price Pressure Hypothesis of Harris and Gurel.

Keywords:

• demand curve
• index reconstitution
• market efficiency
• price discovery
• price pressure

Acknowledgements

This research was funded by the NRF.

Notes

1. Included is a (daily) alpha term in the equation as well, even though this does not materially affect the results.