Many beginner investors aren’t familiar with what happens when a stock is added to the S&P 500. However, the history books show that taking advantage of the S&P 500 inclusion effect can potentially be one of the most lucrative opportunities the market offers. This guide explains what the S&P 500 is. We’ll look at how it works and how stocks behave when they become a part of the index. Let’s examine whether the inclusion effect still works today.
What Is the S&P 500?
Standard & Poor’s 500 Index, or S&P 500 for short, is a market-capitalization-weighted index comprising 500 of the leading listed companies in the U.S.
In layman’s terms, the S&P 500 is “the market.” It includes some of the world’s leading companies from 11 sectors, including IT, health care, consumer discretionary, industrials, energy, real estate, and more. The broad diversification is why the index is considered the best reflection of the U.S. stock market performance.
However, it is worth noting that the S&P 500 doesn’t necessarily include the top 500 U.S. companies by market cap. There are various other criteria that play a part.
Over the years, the S&P 500 had become a global benchmark for the world economy. It’s also of the most traded underlying assets. Why underlying? Because investors can’t directly buy the S&P 500. Instead, they can invest in it through other instruments like futures contracts or ETFs that replicate the index’s performance.
The S&P 500 was launched on March 4th, 1957. Since then, it has been steadily growing with close to 7,000% gains to date. During its first decade, it rose significantly to over 800, reflecting the economic boom following WWII.
Today, S&P 500 is probably the most accurate indicator for the state of the global economy. It often dictates the moves of retail and institutional investors.
How Does the S&P 500 Work?
Many people fail to understand how the index works despite its fundamental importance. More to the point, they don’t know what happens when a stock is added to the S&P 500. We’ll get back to that in a minute. First, let’s focus on how the index is built and calculated.
To help you understand how the S&P 500 works, we should start by saying that it uses the market-cap weighting method to identify the 500 leading US-listed companies. Designed as a float-weighted index, the S&P 500 first takes the market capitalizations of its constituents. It then adjusts them by the number of shares available for public trading (i.e., the free-floating shares). Furthermore, it accounts for each company’s market cap to compensate for new share issues or company mergers.
A company’s market cap is calculated by taking the current stock price and multiplying it by the outstanding shares. The weighting of each company in the index is calculated by taking its market cap and dividing it by the index’s total market cap.
The construction model of the index prioritizes companies with higher market capitalization. Alternatively, the higher the value of a company, the more influential it is on the index’s overall performance.
It is important to note that the 500 companies included in the index aren’t set in stone. It is rebalanced periodically, and new companies substitute those who no longer fit the criteria.
S&P 500 Selection and Removal Criteria
The U.S. Index Committee, comprising full-time professional members of S&P Dow Jones Indices’ staff, maintains the index. Each month, the committee meets to review ongoing corporate actions relevant to the index constituents. It also analyzes and considers companies that are candidates for inclusion.
When it comes to selection and removal criteria, it is essential to know that companies aren’t removed from or added because of future stock price performance. Instead, the committee tries to keep the turnover low. They only make adjustments only when a particular company’s financial status or overall market conditions change.
The complete list of the S&P 500 inclusion criteria is pretty extensive and is available here. In a nutshell, to qualify for the index, a company must have/be:
- A U.S.-listed common stock company (exceptions might apply if their primary listing, headquarters, and incorporation are all in the U.S. and/or a “domicile of convenience”);
- A minimum market cap of a certain size ($13.1 billion as of the November 2021 guidance);
- Be highly liquid;
- Have a public float of at least 10% of its shares outstanding;
- Had its IPO at least a year earlier;
- Maintains positive earnings for the most recent quarter and also for the sum of its trailing four consecutive quarters’ earnings.
Exclusions from the index happen at the committee’s discretion. Events that might lead to the removal of a company include:
- Involvement in a merger, acquisition, or significant restructuring, after which the company doesn’t meet the eligibility criteria;
- A substantial violation of one or more of the eligibility criteria.
If a company is removed, it has to wait a minimum of one year before being reconsidered as a replacement candidate.
Does a Stock Price Increase When it’s added to the S&P 500?
The short answer is – yes, it does. At least, this used to be the case until a decade ago.
This is known as the “S&P 500 inclusion effect.” In a nutshell, studies have observed the pattern that, once a company is added to the index, it generates abnormal returns. The effect is evident mainly on the announcement date and the actual date of inclusion. In a 1986 study, Andrei Shleifer concluded that the companies added to the S&P 500 between 1976 and 1983 experienced a 3% increase in value on average. During the period 1995 – 1999, the effect has resulted in even greater median excess returns of 8.32%.
According to McKinsey, the effect of gaining or losing a place in a primary stock index has only a short-term impact on the share price that lasts about 45 days.
The reason for the S&P 500 inclusion effect isn’t that a company had become more profitable or financially stable overnight. The most common explanation is that the included companies gain more awareness among investors, increased analyst coverage, and a sudden liquidity influx. This is also the reason why the effect weakens over time.
However, a recent study found that the inclusion effect is rare nowadays. According to the findings, companies added to the S&P 500 between 2011 and 2021 have experienced a median excess return of -0.04%. This was likely a result of the structural changes in the financial industry, including the rise of the ETF market and the passive investing ecosystem.
The National Bureau of Economic Research also found that stock increases linked to the announcement of index inclusions have washed away with time, and the lasting effect on price in recent years has been downward.
Examples of Stocks Being Added or Removed From the S&P 500
Companies are added or removed from the index on an ongoing basis. Yet, it is worth noting that the turnover for the S&P 500 is relatively low. Usually, the annual inclusions and removals over the past couple of years have been between 15 and 25. Alternatively, this accounts for a turnover of between 0.03% and 0.05% per year.
In the general case, when a company gets delisted, another one has to join so that the number of index constituents remains the same. And vice-versa.
Here are some notable examples of what happened with stocks that had been added or removed from the S&P 500:
December 21, 2020: Tesla (TSLA) Is Added to the S&P 500
In the period between the announcement of Tesla’s addition to the index (November 16, 2020) and the end of the trading week before it was added (December 18), the stock appreciated 57%.
Upon joining the S&P 500, Tesla received a weighting of 1.69%. It became the fifth most important company for the index’s performance.
However, once the market opened and the investors cashed in, the stock fell 6%. A major reason for this was also the same-day announcement that Apple was moving ahead with its EV project, meaning Tesla was facing another major competitor. Another contributing factor was the overall drop in global equities at the time due to fears of a new coronavirus strain.
December 21, 2020: Apartment Investment Management (AIV) Is Removed from the S&P 500
For Tesla to be added to the S&P 500, another company had to make way. And the one to do so was Apartment Investment Management (AIV).
The reason, however, wasn’t related to financial performance. It was because, in September that year, Apartment Investment and Management Co (Aimco) announced that it would be splitting into two separate companies. On December 11, shortly after the announcement that it was about to be removed from the S&P 500, its stock plunged more than 5%. The actual separation happened on December 15. During that particular month, the stock dropped over 80%.
July 1, 2014: United States Steel Corp. Is Removed from the S&P 500
What makes this case interesting is that the company was a part of the S&P 500 right from its start. It was founded in 1901 by J.P. Morgan through a merger of the Federal Steel Company, the Carnegie Steel Company, and other steel businesses with a capitalization of $1.4 billion. This move made the United States Steel Corp. the first company with a billion-dollar valuation. At one point, it was the largest company in the world.
However, in 2014, it was replaced in the index by Martin Marietta Materials. The reasons for this decision were building up in the prior years. U.S. Steel was long-battling the weak steel market fundamentals, which resulted in losses for each of the five preceding years. In fact, in 1991, it was excluded from the Down Jones Industrial Average index. Additional factors for the unstable financial performance were oversupply in the US market, competition from low-cost Chinese producers, logistic bottlenecks, and more.
In 2013, the company fell below the $4 billion threshold set at the time, and the committee excluded it from the index. It was then added to the S&P MidCap 400 Steel Sub-Industry Index, where it filled the gap left by Martin Marietta Materials, the company that replaced it in the S&P 500.
What is more interesting is that after the announcement date, as well as after its actual exclusion, its share price went up. From July 1 to October 1, 2014, its stock rose over 22% before crashing 70% over the following 12 months.
A Final Remark – Keep Track of Companies Joining and Leaving the S&P 500
Over the years, analysts have noticed a pattern where additions to the S&P 500 typically underperform. Meanwhile, deletions outperform the index in the subsequent year. According to some, the larger the addition to the S&P 500, the more significant the average following performance gap is.
And this was precisely the case with Tesla and Apartment Investment. A little over six months after the companies switched places, AIV was estimated to have a relative return advantage of 78.6% over Tesla.
The basic explanation for this is that companies are often added to the S&P 500 near their highest valuation levels. Alternatively, when they are in good financial health. On the contrary, the ousted companies aren’t usually performing well at the time of exclusion. Such findings have been confirmed on a broader scale. After calculating the return of the initial 500 firms in the index and the new additions over the years, researchers found that the former’s buy-and-hold returns have outperformed the latter’s returns with lower risk in nine of the ten industrial GICS sectors. The main possible reason is the overvaluation of the newly-added firms.
