The index reconstruction effect : An event study on the OMX Stockholm Benchmark Index

Abstract: Background. Due to prevailing technological development, telecommunication and computers have become very advanced. This has had a tremendous effect on the financial markets as well, various facilitating financial means have become much more common. One of such is passively managed index funds which does not only use index as a benchmark but also trade the stocks in the index. Thus, guaranteeing the fund a return equal to the market return and to a lower cost than an equally good actively managed fund. Index funds have in recent times increased in popularity, which has left its mark. The price of the stocks included to and excluded from an index has been observed to respectively increase and decrease in value.   Research on the price effects caused by index revision, or the effects that inclusion and exclusion have on the price of underlying shares, has been around since the 1980s. In the literature, it is generally accepted that inclusion to an index results in a positive price development, while exclusion results in a negative price development. However, the literature does not agree on whether the price effects are long-term or short-term. The disagreement began with the first studies in the field, where one author found that the price effects were long-lasting, even permanent. The others, on the other hand, found that the price effects were short-lived and returned to their original value when the trading ceased. Subsequent research is equally inconsistent. Some studies have found temporary changes, and some have found permanent ones. In this uncertainty, different theories of explanation have also been presented for the different outcomes, but these do not agree either. Objectives. To bring some clarity to the problems within the literature, the purpose of this study is to investigate the stock price effects from the reconstruction of a Swedish market index, with consideration of whether the effects are temporary or permanent. Methods. This study applied the event study methodology and the market model to examine the abnormal return found around the announcement day and the changing day. The study is based on 195 stocks that were included to and excluded from the OMX Stockholm Benchmark Index between the years 2009 and 2019.  Results. This study did not find any statistically significant price change in the period before the announcement date. However, there were indications that the announcement day did have a positive effect on the included stocks and a negative effect on the excluded stocks. But the time after the announcement day and prior to the changing day did not show any statistically significant price changes. The changing day and the period after were both found to be negatively significant for inclusions. Thus, indicating a negative price effect on the day of inclusion and the period that followed. These results are consistent with previous studies that have found a price drop on the changing day and the following period. A further test of the relationship between the abnormal return found on the announcement day and the changing day revealed that the price increase was concentrated to the announcement day. A possible explanation for this outcome may be that index funds that trade on the Swedish exchange have recognized the opportunity to trade closer to the announcement day without incurring any losses and acted accordingly. Regarding the exclusions, the changing days were not found to be statistically significant. Neither did the period following the changing day show any statistical significance. This result could be due to a delayed reaction to the changing day, given that this group showed a slow reaction to the announcement day as well. Both the announcement day and the day after the announcement day were statistically significant at the 1% level. Other possible causes for the deviating results are errors in execution or data. Conclusions. The result of this study is consistent with other studies that find a temporary price reaction to the index reconstruction.