Does Joining the S&P 500 Index Hurt Firms?

Benjamin Bennett is Assistant Professor at the Tulane University A.B. Freeman School of Business; René M. Stulz is the Everett D. Reese Chair of Banking and Monetary Economics at the Fisher College of Business at The Ohio State University; and Zexi Wang is an Assistant Professor at the Lancaster University School of Management. This post is based on their recent paper.

For investors wanting to hold common stocks, the best-known investment textbooks show that it is hard to do better than investing in a low cost indexed fund. However, little is known about whether firms benefit from being included in the S&P 500 index. Joining the S&P 500 index can have both positive and negative effects on a firm. Being added to the index is like joining a prestigious club. A firm gains prestige by joining the club, but at the cost of becoming compared to other firms in the club. On the positive side, the increased demand for the stock from passive investors may increase the value of the stock and the firm gains prestige. On the negative side, the increase in holdings by passive investors implies that more investors ignore firm fundamentals when they make decisions about their holdings of the firm’s stock, so that the stock price may become less informative and governance may become worse. Further, active investors, managers, and board members become more likely to assess the firm relative to other firms in the index even though the index addition itself does not directly change the firm’s fundamentals.

We show that joining the index has real effects on firms and that some of these effects change over time. While joining the index has a transitory positive effect but no long-term effect on stock prices in the first half of our sample period, stock prices of firms joining the index experience no transitory positive effect and negative risk-adjusted long-term returns in the second half of our sample period. We show that price discovery for a firm’s common stock worsens when a firm joins the index but this effect does not worsen as passive investing increases. We find that index inclusion affects the investment, payout, and financing policies of added firms. Though payout and financing policies of included firms commove more with the payout and financing policies of their S&P 500 peers after inclusion, we find increased comovement with investment only if we measure investment by asset growth and not when we measure it by capital expenditures. In no case do these effects increase over our sample period. We also find that firms in the index repurchase more and that firms joining the index increase repurchases. A plausible explanation for this evolution is that managers of added firms see the number of S&P 500 firms in their compensation peer group increase, so that they are more compared to firms in the index after inclusion than before. Belonging to the index conveys valuable prestige. This prestige may explain why firms added to the index experience a credit rating increase. This increase is stronger earlier in our sample period. There has been much debate in the literature about a potential adverse impact on competition of the increase in passive investment because of the associated increase in common ownership. Using multiple measures of competition, we find no evidence that index inclusion has a competitive impact. In particular, an included firm’s profit margins do not increase and neither do the profit margins of other firms in the industry that are already in the index.

Much earlier empirical evidence shows that a firm’s stock price increases when it is announced that it will join the index. We find that index inclusion announcements are accompanied by stock-price increases in the first half of our sample period (the early period), namely from 1997 to 2007, but not in the second half (the late period). There is a long-standing debate in the literature on whether this price increase is a transitory effect or a permanent effect. Possible explanations for the stock-price reaction include temporary price pressure effects or permanent price effects arising from a shift in the demand curve for the stock. We investigate whether the price effect is permanent. We find that there is no cumulative abnormal return over one year in the early period irrespective of the approach we use. In contrast, there is a significant negative cumulative abnormal return over one year including the month of addition for the late period. This cumulative abnormal return is weaker when we exclude 2008 from the late period, but it is still significant. Consequently, index inclusion appears to have a negative impact on shareholder wealth in the late period but not the early period.

To identify the effects of firm addition on firm fundamentals, we carry out a difference-in-differences (DiD) analysis based on S&P 500 addition. For each treated firm that is added to the S&P 500 index, we select a control firm that is never in the index with similar total assets, Tobin’s q, stock return, and in the same industry one year before the index addition. Matching on stock returns is important because the S&P 500 selection committee is unlikely to include a firm in the index whose stock has performed poorly before the inclusion. We then study the impact of index inclusion on firms’ passive holdings, stock price informativeness, governance, corporate policies, accounting performance, and competition.

The adverse impact of index addition comes from the fact that a stock joining the index becomes included in a new category such that investors make decisions about the stock based on the category it is now included in. Passive investors hold the stock because it belongs to the category and change their holdings of the stock when they change their holdings of the category. Active investors now compare the firm and its policies to other firms in the category. This pushes firm policies to become more similar to policies of index peers even though the decision to add a firm to the index has no direct impact on its fundamentals.

Passive investors do not have to acquire information about a stock to hold it. If passive investors held all stocks, there would be no information production about stocks. We show that information production about a firm’s stock falls after the firm joins the index. Another way to put this is that stock prices are less informative after a stock joins the index. It is well documented that price discovery in the stock market guides managers to make more efficient decisions. If the stock price becomes less informative, we expect firms to make worse decisions. We find evidence that being added to the S&P 500 index reduces a firm’s investment efficiency.

Higher passive holdings likely impact a firm’s governance. Because passive funds simply track the index, they may care little about firm fundamentals and accordingly spend few resources on monitoring the firms in their portfolios. However, it is also possible that passive funds have incentives to improve the governance of the firms they invest in. These funds cannot walk away from a firm in the index because its weak governance leads it to destroy shareholder wealth. Furthermore, the low-fee design of passive funds also means fewer resources and less expertise for monitoring. Existing evidence shows that index fund providers vote more with management and that increases in passive ownership increase CEO power. Both of these changes suggest that index inclusion reduces the incentives for investors to attempt to influence management through block holdings. We find consistent evidence that blockholder ownership is significantly reduced after a firm is added to the S&P 500 index.

Categorical thinking likely impacts actions by the added firm’s board and by its management. As a firm is added to the S&P 500, its board may now think that it is a different firm and that its management should be evaluated differently. We find that after a firm is added to the S&P 500, management’s performance comparison group involves more firms from the S&P 500 even though inclusion does not impact firm fundamentals directly. We then explore how investment, external financing, and payout policies change when a firm is added to the index because of decisions by management. We find evidence that following inclusion investment falls, equity issuance falls, and dividends and repurchases increase. In addition, investment measured by asset growth, equity issuance, debt issuance, dividends and repurchases commove more with those of index peers after inclusion. However, some of these effects are stronger for the early period than the late period.

Our evidence shows that the permanent stock price impact of index addition is negative in the late period. We show that index addition has a real impact on firms. An obvious question is whether this real impact translates into lower accounting performance. We find some evidence that being added to the index increases EPS. However, when we use ROA instead of EPS, we find that index addition is associated with a decrease in ROA. Since firms joining the index increase repurchases, it is plausible that EPS could increase because of the decrease in the number of shares rather than because of an increase in net income.

Finally, we investigate the effects of index addition on market competition. As index addition mechanically increases the common ownership of firms in the index due to the greater holdings by funds tracking the index, index addition may weaken the competition among industry peers within the index, which are generally industry leaders and have a large impact on the competition dynamics. However, it is also argued that index funds generally lack incentives to intervene in the real operations of firms in their portfolios, and therefore, they should not affect competition dynamics in the market.  We find no evidence of an impact of inclusion on competition using measures at the firm level and at the industry level. In particular, we do not observe an increase in profit margins for included firms or for other firms in the industry already belonging to the index.

The complete paper is available for download here.

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