Excess returns for stocks associated with index addition announcements have diminished sharply over time, according to new research from Standard & Poor’s.

According to the ratings agency, there are several structural issues behind the decline of the index effect that suggests this trend will persist in the foreseeable future.

According to the Standard & Poor’s study, the median excess returns between announcement date and effective date of addition for those stocks added to the S&P 500 are 8.9% between mid-1998 and mid-2000, 4.5% between mid-2000 and mid-2002, and only 3.6% between mid-2002 and mid-2004. “The index effect has begun to diminish thanks to changes in the trading environment, and the way index funds handle these events,” explains Srikant Dash, Index Strategist at Standard & Poor’s. “We find that the decline has occurred despite a persistence of excess trading in added stocks, and robust demand of shares from index funds.”

The Standard & Poor’s study suggests that there are three structural issues behind the declining trend:

  1. a surge of proprietary trading activity that seeks to exploit this arbitrage opportunity meaning the profit opportunity has diminished;
  2. many index funds have increasingly begun to trade around the effective date to minimize the cost of index changes; and
  3. an increase in indexed assets for the mid- and small-cap indices provide better offset for additions caused by moves from one index to another, thus reducing net demand.

“The index effect has historically been a much-researched topic,” continues Dash. “Our aim with this study is to not revisit issues related to past studies, but to highlight a shift in the index effect over time, which needs to be factored into trading strategies and research design.”