Effective September 18th, 2023, Grupo Comercial Chedraui will be added to Mexico’s representative equity index covering the top 100 companies in Mexico by market capitalization.
Inclusion forces pro-rata equity participation by any passive fund or ETF that seeks to mirror the returns of the BMV IPC. As Grupo Chedraui represents a rather tightly held corporation, one where the Chedraui family directly owns roughly 59% of the total outstanding shares, it might be assumed, all else being equal, that an imbalance of sellers to match the required buyers could result.
Whenever such an imbalance occurs, the natural solution is for the shares to be repriced to a level sufficiently attractive so as to entice existing holders of an equity to sell off some portion of their investment.
Those who monitor passive index portfolios are aware of the well documented investment implications for an equity once included in an index, referred to as the “index effect”. In the past, investors have historically focused upon the share price improvements noted after inclusion. More recently, investors of all stripes, both institutional and individual, have become aware of the index effect and have made their investment decisions prior to inclusion, resulting in a proportionately smaller benefit after the addition date has come and gone. “For example, it has been well documented over the past three decades that stocks added to a popular index tended to outperform the index between the “Announcement Date” and “Effective Date,” and this was typically followed by a small post Effective Date correction.” (Standard & Poors)
Oddly, if one Googles “index effect”, what comes up is a series of curated articles designed to indicate that the effect is largely dead and that even when reported, is exaggerated as to benefit.
All these articles seem to start and end with one source, Standard & Poors and typically cite a 2021 publication entitled “what happened to the index effect”. They have calculated, in decade long increments, that the index effect gains in excess of about 8% for one decade declined to just 3%+ gains in the next decade and fell into negative gains for the final decade. Yet, a review of the paper seems rather hollow, as though something is missing, something directly in front of the researcher.
When the pre-index gains (after announcement) are added to the post inclusion returns, even according to the S&P report, it very much appears that the index effect remains intact over extended durations of time, albeit to a smaller degree. Is an incremental pickup over 30 years of data, amounting to just under 4% for each equity added to an index, a bad thing? Maybe we need to delve deeper into what has changed over the past 30 years; maybe what has changed is the the starting point to determine the potential effect of equity index inclusion.
If you suspected, with relative comfort, that an equity was highly likely to be promoted to inclusion in an index, would it not benefit you to pre-purchase your shares in anticipation of some arbitrary announcement date provided by the index nominating committee? Why not get the jump over your investment competitors and establish your position a few months early? Would not that date represent the beginning of the equity effect; a time when assumed addition to an index was likely, rather than the day when the announcement was declared via press release? And, if such a notion springs to mind at the retail level, rest assured, institutional investors have also modeled that potential.
Passive index investors lack the ability to jump that line, but most index funds are run under the aegis of large investment firms which also operate actively managed funds. This creates the potential, no, the probability, of the equity investment equivalent to real estate “land banking”. Actively managed institutional accounts will make an assessment on the likelihood of any equity to be added to an index well before the actual date of inclusion, or even the date of the announcement of inclusion, and will begin to assemble a potentially required position by passive accounts on an if\as\when basis. These active equity funds within the same management family will collect the pre-inclusion returns earned on equities and will sell those equities to the passive funds within their umbrella as soon as permissible, once “rezoning” has taken place. The active fund captures the bulk of the gain while the passive investment fund gets to hold the equity after inclusion without further putting upward pressure on the equity.
Almost all of the index effect research published and most widely quoted, is based upon S&P 500 equities.
This serves the purpose of the institutional equity investors holding the largest 500 companies. In many cases the studies were commissioned and published by Standard & Poors themselves. Critical thinking now becomes of utility for the reader. The largest 500 companies based upon cap weight, profit and a few other criteria were not always so large. At one time, they were inconsequential, then reached the first ladder of corporate awareness and were included in a smaller index. Over time, they worked up through other indexes and eventually arrived at the feet of the S&P 500 nominating committee. So, a company that becomes a core component of the S&P 500 is certainly already also a constituent of another index, perhaps multiple indexes, and perhaps has reached the bulk of institutional passive investors. If this is the case, that would explain an incrementally smaller index effect as there are more passive investors, based upon overall investment capital, than ever before.
There has been an explosion of new indexes created to hold various equity investments in the past two decades. Could it be argued that with the addition of each and every new index, a smaller, but more frequent series of index effects occurs for each company that is added to various indexes? Is it possible that with the total number of global, regional and sector indexes, there is just less total index benefit for one equity when added to the S&P 500, because by the time an equity gets into the S&P 500, some of the abnormal index gains have already been accrued along the way through inclusion into the many other indexes offered?
It is also reasonable to conclude that as a company ascends into increasingly larger cap weight based indexes, its awareness by both active and passive investors grows apace. Therefore, is it not unrealistic to conclude that a blanket declaration of the diminished relevance of the index effect may be flawed due to a very narrow focus upon a sample size of just 500 companies? In pharmaceutical trials, the smaller the sample size, the less likely it is that the study is considered to be reliable. Yet, a sample size of exactly 500 companies, in a global market containing more than publicly traded 58,000 firms, less than 1% of the equities in the marketplace, is deemed authoritative to the point that discussion of the index effect is now closed.
However, what does the index effect mean to a company that has never been represented in any equity index beforehand? Those studies are significantly harder to come by; I suspect by design.
To disregard cap weighted index moves out of hand, I surmise, largely due to studies put forward by the sponsors of a single index, which subsequently form both the starting and endpoints of other researchers to replicate, would clearly represent a no-no in the scientific world, yet is accepted as largely sacrosanct by the investment community; that seems odd.
Everyone innately understands that inclusion to an index does something to an equity price, and that something is positive. Absolutely everyone who has had the fortuitous experience of having an equity they own enjoy a “pop” in the share price upon the news and subsequent inclusion in an index has experienced the effect. So, what is the purpose of S&P putting out a series of reports stating that the effect no longer exists? Could it actually be propaganda? And if so, to what end; why tell us that something that is so consistently known as being a good thing doesn’t actually take place anymore? Winnowing through the chaff is required to obtain an unbiased perspective; for the most part, it appears that the primary and obvious purpose of the most recent research downplaying the index effect is to dissuade individuals from considering a means of enhancing return, one employed with great benefit by institutions that have active and passive funds within their stable. Institutional investors would very much prefer to keep their secrets to themselves; “nothing to see here, just move along“.
To a cynic, a proliferation of highly similar promoted articles could appear to be designed to “trick” an AI algorithm into declaring, upon a search, that “the index effect has been largely debunked based upon multiple recent studies“. That’s what AI does, it engages in brute force rote learning, not any engagement in critical thinking. So, a repetition of similar articles, many seemingly planted and promoted by a different algorithm, result in the fostering of an illusion of truth, or as it is known, “truthiness”, all ultimately causing an AI chatbot to intimate the paper increase in my Chedraui equity holdings today didn’t actually occur, because S&P said so. It is circular logic, but with a purpose. I defer to smarter persons to assess whether this purpose is altruistic, benign or potentially detrimental in intent.
Institutions also prefer to keep their list of potential index equity candidates to themselves, even though assembly of any potential list is completely within the ability of any individual to develop, really little more than a simple cap weighted model, with some other stuff thrown in that would normally be expected from any top 500 corporation trading in the USA. But don’t try it, because there’s no benefit, what with the index effect being disproven and all.
Purchasing any equity simply due to an announcement of its inclusion into an index is unwise on its face.
One must really like the underlying business case of any equity, first and foremost and it must also make sense within an overall portfolio framework. Forced participation from index investors is simply icing on the cake. We have to want to own an equity exclusively on these parameters, because both Artificial Intelligence as well as Standard & Poors have decided that the equity effect doesn’t actually exist, so that’s that. Who knew?
https://www.prnewswire.com/news-releases/grupo-comercial-chedraui-sab-de-cv-announces-inclusion-to-the-spbmv-ipc-index-301917026.html
https://www.spglobal.com/spdji/en/documents/research/research-what-happened-to-the-index-effect.pdf
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