Photo: Frodo013 CC BY-SA 3.0
The quarterly review of the FTSE 100 and FTSE 250 indices, an event eagerly awaited by investors, traders and market makers in UK equities, is due to be unveiled by the FTSE this Wednesday.
It is anticipated that four companies — Autonomy Corporation, Fresnillo, Inmarsat and Pennon — will be promoted to the flagship FTSE 100 index. Passive investors, including index-tracker funds, closet trackers, and exchange traded funds, will be obliged to buy heavily into the four newcomers.
Meanwhile Carphone Warehouse, Enterprise Inns, ITV and Ferrexpo, all expected to be ejected from the FTSE 100 on “implementation day” (22 September), will almost certainly experience significant investment outflows.
However, active investors seeking to gain from these flows of dumb money are already too late, according to new research from the University of Edinburgh Business School, sponsored by Aberdeen Asset Management.
“The hot money has already been and gone,” says David McCraw, head of structured products at Aberdeen Asset Management and portfolio manager on the Edinburgh UK Tracker Trust. “The research we commissioned shows that, if investors wait until the review date [this Wednesday], they will be too late to profit from any excess returns. That is quite different to what happens in the US market.”
Edinburgh University’s analysis examined the period from June 2001 to September 2005, when there were 214 additions and 202 deletions to the FTSE 350 index. The aim was to establish whether companies joining and leaving the two indices generate “statistically significant abnormal returns” as a result of their changed status.
The study has confirmed that active investors are able to generate outperformance by predicting changes to the index — and that this is much easier to achieve in the UK than the US, since changes to the composition of British indices are more transparent. However, the research also found that investors in UK equities need to act early and rely on calculated guesswork if they are to profit from index changes.
This was because the period of greatest outperformance for putative newcomers to the FTSE 100 occurred in the 30 day build up to “review” day (when their revised status is confirmed by the FTSE committee). However, in contrast to what happens in the US, these gains are invariably wiped out in the six trading days between review and implementation day.
Another finding was that companies due to be relegated from UK indices marginally outperform their benchmarks in the six days between review and implementation. However, in the 30-day build-up to review day, these stocks significantly underperform the index.
Deleted stocks revert to underperformance for a further 10 days after implementation day before entering a period of outperformance.
Mr McCraw, however, says there are dangers in front-running such index changes — meaning buying or shorting possible candidates for promotion or demotion on the assumption they will be promoted or demoted. “Thirty days is quite a long time in the market, and a company that seems certain to join the index might easily suffer a negative event, such as a profit warning, in the intervening period,” he says.
The research also threw up some interesting findings for managers of index-tracking funds, which Mr McCraw says is relevant to Aberdeen, since it manages about £3.5bn in this way.
“For passive investors, the research revealed the dangers of front-running changes to index constituents in the six-day period between the review and implementation,” he says. “The research suggested passive managers are much better advised to implement changes to their portfolios immediately after implementation day.”
Share price responses to changes in stock market indices have already been heavily researched in the US. Surprisingly, it has been less closely scrutinised in the UK and continental Europe.
US research suggests stocks added to the S&P 500 Index experience, on average, positive abnormal returns from the day their promotion is announced until the day it is implemented, with a partial reversal once they officially join the index. The pattern of share price behaviour for demoted stocks is similar but in the opposite direction.
The different share price responses on either side of the Atlantic can probably be explained by the different methodologies used by FTSE and Standard & Poor’s when deciding on the make up of their indices.
Alistair Byrne, senior lecturer in finance at Edinburgh University Business School, says: “Trading on index changes is a very short-term strategy that is probably more suitable for hedge funds and proprietary trading desks than for institutional fund managers.
“But if an institutional money manager’s research has thrown up an opportunity among stocks that are due to be promoted or demoted in any given quarter, they can benefit by timing their buying accordingly.”
This article was published in the Financial Times’ weekly asset management supplement, FTfm, on Monday, 8 September 2008. To read it on the Financial Times website click here.