Index Committee Or Index Rules?

April 26, 2012

Not only do market participants looking to evaluate the long-term characteristics of indices need to forecast the stock price performance or changes to the corporate and shareholder structures of companies at or near the index threshold, they also need to evaluate the committees' likely decision and timing. One example for this is the case of General Motors: the company's large stock price decline in 2008 and 2009 saw the share drop out of the group of the largest US-listed companies. While Standard & Poor's adjusted the S&P 100 Index as early as July 2008, it took until June 2009 until the share was finally dropped from the Dow Jones Industrial Average, which comprises only 30 stocks. It was around the same time that Standard & Poor's dropped the firm from the S&P 500 Index, indicating that GM was at the time in fact no longer reasonably within the largest 500 stocks in the US, let alone the largest 30. In rules-based indices, similar declines in market value would lead to a much quicker exclusion from the index. The STOXX Europe 50 Index applied its fast exit rule in December 2011 to replace French insurer Axa, which had fallen below the threshold for inclusion. In Germany the share of Infineon was dropped from the DAX index in March 2009 following a sharp decline in its market value, triggering a fast exit. Incidentally, the company returned to the index six months later after a sharp recovery in its share price.

Inneon's Market Capitalisation And Capitalisation Ranking
For a larger view, please click on the image above.

It is exactly this rapid exclusion and re-inclusion of index stocks that committee decisions attempt to remedy—by taking an active view on the future performance of certain components. Unfortunately the case of Infineon remains a rare example—most companies leave an index for good and the added value of delaying the exclusion for the sake of continuity seems questionable. In Figure 3, we give the statistics for companies that have re-entered a blue-chip index from which they were previously excluded. The statistics show that such occurrences have been very rare in the past ten years and that on average such companies have taken almost two full years to return to the index, justifying the exclusion in the first place.

Re-Entries Into Major Market Indices, 2000-2011g
For a larger view, please click on the image above.

The obvious exception in this table is the FTSE 100 index, which shows a high number of returning companies. During the period, companies such as Whitbread, Tate & Lyle and Kelda Group returned to the index twice or more. In this case, the buffer of 10% chosen to prevent frequent changes to the index composition seems to be too small to achieve its objective, especially given the relatively small and hence quite volatile market capitalisations at the lower end of the FTSE 100.



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