Seven Questions for Jenn Bender, Rohit Nagori and Mitesh Tank
River Wu, a portfolio specialist for our equity indexing strategies, recently sat down with our research team to discuss their paper which explores new dimensions of a longtime value-creation opportunity.
River: Could we start by defining what the “index effect” is?
Jenn: The term “index effect” refers to the excess returns (positive or negative) that stocks being added to, or deleted from, an index experience between the announcement date of a change in index composition and the actual index change date. There has been extensive research measuring the value-add opportunity represented by the index effect over the last 30 years, as well as anecdotal evidence which suggests that arbitrageurs and active managers have sought to capitalize on this effect since it was originally noted. Much of the original research on this topic was tied to the S&P 500.
River: What caused you to revisit, and expand on that research?
Mitesh: With the remarkable growth in indexed assets in the last few decades, investors are increasingly interested in the index effect, both as a way to add value in a world where alpha has become harder to generate, and for what it says about the impact of indexing on overall market efficiency. Being able to add incremental returns in indexed mandates is not new, but the relevance of this approach has grown as traditional stock-picking methods have been challenged in the face of faster and broader information access for all market participants. Meanwhile, regulators concerned about the ramifications of indexing on market efficiency are also focused on the index effect as a way to gauge the overall impact that indexing has on security returns. The market microstructure continues to evolve, and we wanted to get a grasp on the direction and amount of change in the “index effect.”
River: Updating prior research, what did you find?
Rohit: We found that the potential value-add opportunity1 of the index effect no longer exists for the S&P 500 and, more generally, is marginal for the most popular US Large Cap stock indices. However, in certain pockets outside of US Large Caps, such as Emerging Markets and Developed Market Small Caps, the potential value-add opportunity of the index effect was still sizeable.
River: Do you have thoughts about why the index effect differs among similar indices?
Rohit: One possible explanation for the disparity could be a correlation between value-add opportunity and turnover2. The average turnover for the S&P 500 between 2010 and 2018 was 45 basis points (0.45%), compared to 177 basis points (1.77%) for the Russell 1000 and 152 basis points (1.52%) for MSCI USA. Turnover is one of the key dimensions upon which the index effect depends. But we needed to continue our research around other possible drivers.
River: What dimensions of the index effect did you explore, and what did you discover?
Mitesh: It was clear from our early observations that we needed to study the index effect across a wide variety of dimensions. Our latest research highlights the differences in index-related value-add opportunity for index additions compared with index deletions. We also explored, at a security level, how liquidity (or illiquidity) impacts the index effect value-add opportunity.
River: Given that the index effect is changing (and even disappearing in certain instances), how did you expand the research to uncover new opportunities?
Mitesh: For several indices we modelled the index effect that would result if trading on expected index changes was possible closer to the cut-off period prior to the rebalance announcement. This shift substantially boosts the value-add opportunity, and the strategy turns out to be not as large a risk as it might otherwise appear; this is because reasonably effective prediction models can be built. Any increase in value-add opportunity might warrant consideration of this tactic by those seeking to capitalize on the index effect.
River: As a wrap-up, what would you say are the key takeaways we should remember from your research?
Jenn: First and foremost, index effect value-add opportunities continue to exist in specific indices across specific dimensions, but they do vary in magnitude and risk. Second, predicting index changes ahead of the rebalancing announcement date can potentially produce the greatest value-add. Our research reinforces the fact that, as the indexing space continues to change and expand, the nature of the index effect will continue to evolve. Last but not least, because every penny matters in today’s return-starved environment, we firmly believe that long-term institutional investors could benefit from index effect-related value-add opportunities (within conservative risk budgets) if implemented through a systematic approach based on rigorous and nuanced research.
Jennifer Bender is a senior managing director in global equity beta solutions at State Street Global Advisors; Rohit Nagori is a quantitative research analyst in global equity beta solutions at State Street Global Advisors; Mitesh Tank is a vice president in global equity beta solutions at State Street Global Advisors. River Wu is an equity portfolio specialist at State Street Global Advisors.
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1The total return of buying additions at market close on the analysis date compared with the market close of the index rebalance date minus the total return of selling deletions at market close on the analysis date compared to the market close of the index rebalance date. 2The sum of absolute weight changes considered for analysis.
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