Thursday, June 9, 2011

Buy stocks that leave the S&P 500

At some point I'm pretty sure I've seen data showing stock prices are inflated when they are first included in S&P 500. Since so much money tracks the index and has to then include the stock in their holdings, adding a new company to the S&P 500 causes a huge amount of buying in a concentrated amount of time driving the price of the new company's stock up.  This price increase would not be because the company had inherently increased in value, but simply a result of it now being included in the index, so the price would return to a true market value shortly after.

I was wondering if there would be a similar effect for companies leaving the S&P 500 list, if their stock would be falsely deflated due to a huge amount of selling from index funds and might later return to a true market value.  If so, and assuming no major banks or investment houses have taken advantage of it which is a big if, this would present a small market inefficiency that could potentially be profitable.

I'm betting that if there is such an effect I'm hardly the first person to come up with it and it's already disappeared because of large institutions taking advantage of it. I'm also guessing that any remaining inefficiency is too small for individual investors like me to turn a profit on it after fees.  What do you think? Also, can you find that data I'm thinking about or am I just making it up?  I can't seem to find it, but it makes some degree of logical sense.

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  1. I haven't read about any studies on this effect, but I'm sure you can run some tests where you backtrack historical data on the last 10 companies to get dropped from the S&P500.

    However IMHO, the day to day fluctuations are just too unpredictable. I personally haven't noticed companies depreciating significantly in value after removal from the S&P.

    If you're pretty confident that this phenomenon exists, you can always use options to short a company that's leaving the S&P? That way even a tiny inefficiency could yield some pretty nice profits. Too risky for my taste though.

  2. I agree, too risky. Honestly I'm too chicken to pursue strategies like this (even if I thought they could pay off). I'm really just an armchair speculator - all my money is in index funds.

  3. I'm sure this has been exploited, but that said, things that are exploited do eventually become profitable again. Natural markets have this effect. Someone finds an edge, everyone else finds out about it and ruins it, then everyone else leaves, and the edge returns until efficiency is realized.

    There is actually a strategy that calls for investing in companies that cut back on their dividend, which contradicts the popular view of investing in "aristocrats," those which increase their dividends over time. This strategy has been markedly successful, mostly because dividend-paying companies attract dividend investors in wholesale, when then make a quick exit of the firm once it slashes its dividend. Then the opportunity is opened for people who don't need cash flow to buy a security for far less than dividend investors were willing to pay for it.

  4. JT - Great point. I hadn't hear about the dividend slashing strategy but it definitely makes sense since I've read plenty of investment advice centered around dividend income.