We experienced a relatively quiet trading day in the US overnight with both the S&P 500 and the Nasdaq up modestly.
- S&P 500 = +0.38%
- Nasdaq = +0.24%
- Aussie dollar up 0.5% to 65.30 US cents
- Iron down 0.7% to $94.45 US a tonne
What is “the index effect”?
The index effect was a term coined to explain the stock price movements when a company is added to a major share market index like the S&P 500 for example. When a company is included in an index all rules-based index tracking funds, listed or otherwise, will purchase the company on the effective date. The effective date is usually announced a few weeks in advance with the rebalance.
Research from the US shows that inclusion in a major index, like the S&P 500, in the 90s resulted in an average price increase of 7.4% but by the 2010s this had declined to approximately 0.3%. The same trend was observed when a company was dropped out of the index. The reason for this was greater liquidity levels and the creation of more indicies down the market cap size e.g. mid cap indicies. This means companies entering the 500 would have already been in an index – and at the top of that index – and it would be simply migrating from one to the next.
Where the index effect has still been observed though, is in less efficient markets such as global small caps and emerging markets.
Does this happen in Australia?
Are we seeing a similar effect in Australia? The answer is maybe. Fund managers like Forager’s Steve Johnson is acutely aware of it. Steve and I spoke about it in this live session – see the value emerging section. But it is less likely the passive index funds pushing prices up but more a combination of events.
Yes, there will be some impact from market makers buying for index funds but it is more likely to be market cap increasing and coming into the filters/screens of larger institutional buyers who were not previously able to purchase. As a company increases in size, more and more analysts are able to cover it because they may actually be able to place money in it whereas when it was a micro-cap they were unable to.
Where index investing is helping the smaller cap market in Australia is through the exit of cash from the small end into large cap ETFs. Additionally, industry superfunds are now benchmarked to the ASX 300, the incentive for them to hunt in the small cap market has greatly diminished and the incentive to closet index has greatly increased.
This capital outflow creates inefficiencies and volatility for the active manager to benefit from. This is why we anticipate a growing trend in active managers being able to outperform into the future.
