The competitive effects of S&P 500 Index revisions

• Author: Sheng‐Syan Chen,Yueh‐Hsiang Lin
• Published date: 01 July 2018
• Date: 01 July 2018
• DOI: http://doi.org/10.1111/jbfa.12312

DOI: 10.1111/jbfa.12312

The competitive effects of S&P 500 Index revisions

Sheng-Syan Chen1Yueh-Hsiang Lin2

1Departmentof Finance, College of Commerce,

NationalChengchi University, Taipei 11605,

Tai w a n

2Departmentof Finance, College of Business,

NationalTaipei University of Business, Taipei

10051,Taiwan

Correspondence

Yueh-HsiangLin, Department of Finance,

Collegeof Business, National TaipeiUniversity

ofBusiness, No. 321, Sec. 1, Jinan Rd., Taipei,

Taiwan.

Email:nelsonlin@ntub.edu.tw

JELClassification: G14, G31, L22

Abstract

Firms added to the S&P 500 Indexgain a competitive advantage over

their non-S&P 500 industry competitors. They experience positive

stockvaluation effects at the expense of competitors. The inclusion is

associated with both reductions in financial constraints and the cost

of equity and increases in capital investment for the newly added

firms. When the increase in capital investment is greater, they gain

more market share and enjoy better valuation effects. Rivals’ share

price responses are negatively related to the announcement effect

of the newly added firm. Deletions from the index, however,do not

have symmetric effects.

KEYWORDS

announcement effect, capital investment, competitive effect, index

revision, marketshare

1INTRODUCTION

An extensiveliterature shows a positive share price effect for firms newly added to Standard & Poor's (S&P) 500 Index

at the time such an announcement is made. The early research argues that the positive effect arises from a shift in

the downward-sloping demand curve for the new additions, either because securities are not close substitutes for one

another (Beneish & Whaley,1996; Lynch & Mendenhall, 1997; Shleifer, 1986), or because investorswho accommodate

demand shifts must be compensated for trading costs and risks (Harris & Gurel, 1986). More recent studies suggest

that the increase in share prices for the newly added stocks may be explained by improvedliquidity (Becker-Blease &

Paul,2006; Chordia, 2008; Hedge & McDermott, 2003); enhanced investor awareness (Chen, Noronha, & Singal, 2004;

Zhou, 2011); reduced cost of equity (Baran & King, 2012); and added information about better cash flow prospects

conveyed to the market (Denis, McConnell, Ovtchinnikov, & Yu, 2003). Our research adds a new dimension to this

literature in that we relate enhanced competitive advantages to index inclusion itself and consider the competitive

impact of index inclusion on industry peers.

The competitive effects of index inclusion have important implications for investors, industry peers, and newly

included firms. A simple look at the stock price reaction for index inclusion firms does not reveal whether other firms

in the same industry are affected by inclusion announcements. Investors making portfolio allocation decisions would

like to know how the inclusion of one firm affects the stock prices of its competitors. The share price effects for the

new index firms alone also do not tell us how other firms in the same industry are affected by changes in the compet-

itive structure of the industry. Firms competing with new indexfirms need to know how to respond to such changes.

Finally,new index firms might benefit from reduced agency and information asymmetry problems because of increased

J Bus Fin Acc. 2018;45:997–1027. wileyonlinelibrary.com/journal/jbfa c

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998 CHEN ANDLIN

monitoring and greater production of information by investors and analysts following the inclusion (Baran & King,

2012; Chen et al., 2004; Denis et al., 2003). These advantages might give such firms more access to capital markets

and thus financing for future investments (e.g.,Campello et al., 2010; Denis & Sibilkov,2010; Hubbard, 1998; Li, 2011).

A reduced cost of equity resulting from improved stock liquidity and enhanced investor awareness also expands the

set of investment opportunities for new index firms (Baran & King, 2012; Becker-Blease & Paul, 2006; Chen et al.,

2004). Thus, new index firms gain a competitive advantage over their industry peers due to increasing investmentin

the product market (e.g., Almeida, Campello, & Weisbach, 2004; Byoun & Xu, 2016; Campello, 2003; Chen & Wang,

2012; Chevalier& Scharfstein, 1996; Froot, Scharfstein, & Stein, 1993). In other words, newly included firms may enjoy

increased product market share and improvedshare price performance, advantages directly related to index inclusion

itself.

We examine the stock performance of newly included firms and their industry peers around S&P 500 Index addi-

tions over the period 1976−2011. We confirm that the average announcement-period abnormal return for newly

included firms is statistically positive. Wealso find that industry rivals that are not included in the S&P 500 Index expe-

rience a significantly negative share price response. The results suggest that index inclusion permits the newly added

firms to gain a competitive advantage overindustry rivals.

We investigate how new index firms can successfully compete against their industry peers. We confirm previous

findings that newly added firms without S&P rivals are associated with significant increases in share turnover,analyst

following, institutional holdings, number of shareholders, and capital investment, and significant declines in shadow

cost and cost of equity.1We add to the literature by showing that newly added firms also experience significantly

reduced financial constraints, suggesting that index inclusion is associated with better access to financing. Increased

stockliquidity, improved investor awareness, diminished agency,and information asymmetry problems associated with

inclusion together are related to reduced cost of equity, financial constraints, and increased investment for newly

added firms.

The evidence remains valid for industry-adjusted figures, indicating that post-addition changes in the characteris-

tics of newly added firms cannot be explained entirely byindustry factors.

Wefurther show that newly added firms are associated with significant market share gains surrounding index inclu-

sion. The expansion in market share is positively and significantly related to the change in these firms’ capital invest-

ment. The evidence indicates that index inclusion advantages newly added firms in the product market. Our findings

continue to hold when we use the industry-adjusted change in market share or when we replace the change in market

share with sales growth.

We investigate whether the announcement return for new index firms is related to the competitive effects in the

product market. If the change in capital investment following indexinclusion is positively related to the market share

gain for newly added firms, their announcement-period abnormal stock returns should also be positively related to

their investment change. As expected, we document a positive and significant relation between the announcement

return of newly added firms without S&P rivals and their capital investment change surrounding index inclusion. This

result suggests that the favorableshare price responses of newly added firms are related to their stronger competitive

positions in the product market.

We also examinewhether rivals’ share price responses to index inclusion are related to the announcement effect of

new indexfirms. As the announcement return of newly added firms without S&P rivals is positively related to their cap-

ital investment change around index inclusion, the announcement return should be negativelyrelated to rivals’ share

price responses. We document that rivals’ share price responses around inclusion announcements are negatively and

significantly related to the announcement-period abnormal return of newly added firms. The evidence indicates that

the share price responses of industry rivals are more unfavorable when theysuffer more competitive disadvantage in

the product market arising from the higher investmentof newly added firms.

1See,for example, Baran and King (2012), Becker-Blease and Paul (2006), Chan, Kot, and Tang(2013), Chen et al. (2004), and Denis et al. (2003).