IT is widely assumed that a stock’s price will rise when it is added to a major stock market index. As is often the case with conventional wisdom about the stock market, however, the truth is more complicated.
In fact, a new study has found that over the long term, stocks that are dropped from an index generally outperform those that are added.
The study, “The Long-Term Impact from Russell 2000 Rebalancing,” has been accepted for publication by the Financial Analysts Journal. Its authors are two assistant professors of finance, Jie Cai of Drexel University, and Todd Houge of the University of Iowa.
The professors focused on the Russell 2000 index, perhaps the most widely used benchmark for small-capitalization stocks. While they didn’t study other market averages, they say that their findings are generally applicable to any index that — like the Russell 2000 — is constructed on the basis of relative market caps. The professors also say their findings are partially relevant to other indexes, like the Standard & Poor’s 500 and the Dow Jones industrial average, that are constructed by committees that stress factors aside from market capitalization.
The Russell 2000 index, created at the end of 1978, contains the domestic stocks ranked 1,001 to 3,000 according to market cap. Every June 30, stocks that no longer qualify are eliminated, and new ones are added. According to the professors, some 457 companies, on average, were replaced each year from 1979 to 2004.
The researchers found that over this period, deleted stocks proceeded to perform markedly better than their replacements, on average. Over the 12 months after reconstitution, for example, the deleted stocks outperformed their replacements by an average of 9.3 percentage points. In the five years after reconstitution, the difference was 40.1 percentage points.
This pattern was quite consistent. In 20 of the 25 years studied, the average deleted stock was ahead of the average replacement after 12 months. And in all the years studied, the average deleted stock was ahead of the average addition after five years.
In the short term, though, the conventional wisdom seems to hold. Stocks added to the index often received a big price boost over the first few days or weeks, and deleted stocks frequently lag. But the professors found that these effects generally soon reversed.
A combination of factors account for the results, the professors believe. One was the positive momentum of stocks that had performed so well that they became too big to be included in the Russell 2000. Another was the large number of initial public offerings added to the index in a typical year, coupled with their initial tendency to underperform the market for several years thereafter.
BOTH of those factors are well known to market researchers. But another may be more surprising: a price-reversal pattern among stocks that were eliminated from the index because their poor performance made their market caps too small.
This effect is the opposite of the momentum shown by stocks that left the index because their market caps grew too large. In an interview, Professor Houge said he and his co-author were unable to determine why these poor-performing stocks soon became market beaters. But he did say that they were puzzled by the pattern.
Whatever causes these factors, Professor Houge said they should help managers of small-cap mutual funds bolster their returns with a fairly simple strategy: invest in stocks that are deleted from the Russell 2000, and avoid initial public offerings in the first few years after they come to market.
Assuming that the future is like the past, he said, such a strategy will beat the index in a large majority of 12-month holding periods and in virtually all five-year periods.
Could investors beat the S.& P. 500 by pursuing a similar strategy? Professor Houge said the answer was less clear for such an index, because stocks are often added or deleted from it for reasons having nothing to do with relative market cap. He noted, however, that other researchers have found that investors would have fared markedly better over the years had they stuck with the original S.& P. 500 stocks instead of going along with the changes made by their selection committees.
One way to avoid the problems associated with frequently rebalanced indexes, he said, is to invest instead in an index fund that is benchmarked to the entire stock market, such as the Vanguard Total Stock Market fund.
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