When one of your stocks is added to a benchmark index, you might get a thrill: Trading volumes spike as index funds catch up with the changes, and share prices tend to rally on the spike in demand.
Sadly, the thrill doesn't last.
Three names were added to the S&P/TSX composite index on Monday – Brookfield Infrastructure Partners LP, Spin Master Corp. and Trican Well Service Ltd. – and all three saw trading volumes spike on Friday, the last day of trading before the changes kicked in.
In the case of Brookfield Infrastructure, 18.4 million units traded hands in Toronto (the units also trade in New York), or about 10 times the previous day's volume. Spin Master (which also trades in New York and Toronto) also saw a tenfold increase, while Trican saw a threefold increase.
Any mutual fund or exchange-traded fund that tracks the benchmark index is now a shareholder in these three names.
Share prices followed these sudden upswings in trading volume. Most notably, Brookfield's units shot up more than 5 per cent in the closing minutes of trading on Friday.
Spin Master's units rose 1.3 per cent, after upbeat comments from its chief financial officer: "Our inclusion in the index will contribute to increasing Spin Master's visibility in the investment community and further broaden our shareholder base," Mark Segal said in a statement.
Lastly, while Trican shares fell 1.3 per cent on Friday, they had risen about 10 per cent over the previous three trading days.
None of this is unusual. Nor is the fact that all three stocks fell on Monday, by as much as 1.7 per cent in the case of Spin Master.
The impact of index inclusion has been studied far and wide, and a 2004 study by McKinsey & Co. offers a particularly clear conclusion about the investing merits: Yes, shares can rise when a stock is added to an index, but the positive effect of inclusion is short-lived.
The consultancy looked at the 103 additions to the S&P 500 between 1999 and 2004. It found that while share prices tended to perform well, on average, after the stocks have been tapped for inclusion into the S&P 500, the positive returns disappeared within about 20 days.
"In the end, there was no permanent price premium for new entrants to the S&P 500," McKinsey said in its report. "This underlines the fact that the value of a stock is ultimately determined by its cash-flow potential, unrelated to membership in a major equity index."
Recent changes to the way that S&P Dow Jones Indices calculates which companies deserve membership in the S&P/TSX composite index may be complicating things.
To make the index, companies must meet certain stock price, market capitalization and liquidity thresholds. As of August, though, the liquidity threshold – essentially how many shares trade hands – has been relaxed. Now, companies that are listed in Canada and the United States can include shares traded on U.S. exchanges in their liquidity calculations.
This may have helped Spin Master, whose shares trade in New York as well as Toronto. And it appears to have helped Brookfield Infrastructure as well. Not only does the company's units trade in New York and Toronto, but it announced a $1-billion (U.S.) equity offering last week that increased its unit count by 24 million.
"In our view, the most notable aspect of the timing with Brookfield Infrastructure Partners' offering is [that its] closing roughly coincides with the S&P/TSX composite index inclusion," Andrew Kuske, an analyst at Credit Suisse, said in a note.
But is Mr. Kuske particularly bullish? Not really. He saw the units as a "tactical trade" in June, when Brookfield Infrastructure's membership into the composite index looked likely, but hadn't been announced. Now, he has a lukewarm "neutral" rating on the units, based on valuation.
There may be good reasons to invest in the S&P/TSX composite index's three new members. But for long-term investors, index inclusion isn't one of them.