Evidence on Stock Price Effects Associated with Changes in the S&P 600 SmallCap Index

Quarterly Journal of Finance and Accounting, Winter 2006 by Docking, Diane Scott, Dowen, Richard J

Two widely recognized indices of the performance of small capitalization stock are the Russell 2000 Index and the S&P 600 SmallCap Index. While there have been many studies on the effect of the addition of a stock to an index, two recent and important studies are Chen, Noronha, and Singal (2004) and Biktimirov, Cowan, and Jordan (2004). Chen et al. (2004) find evidence in support of the investor awareness hypothesis for the S&P 500 Index, while the Biktimirov et al. (2004) study supports the price pressure hypothesis for changes in the Russell 2000 Index. We contribute to the literature by explaining this difference as relating to the manner in which the Standard & Poor's and Russell indices are constructed. In this paper, we examine the returns effects associated with changes in the S&P 600 SmallCap Index and find evidence supporting the investor awareness hypothesis.

Introduction

A large body of literature focuses on the market effects of changes to the S&P 500 Index. These studies consistently show significant, positive (negative) reactions when firms are added to (deleted from) the S&P 500 Index. While previous studies recognize that these market effects occur, disagreement exists as about the explanation for these stock price reactions.1

More recently, a study by Chen, Noronha, and Singal (2004) documents an asymmetric price response to changes in the S&P 500: a permanent increase in the price of added firms, but no permanent decline for deleted firms. Their results support the investor awareness hypothesis that asserts changes in investor awareness contribute to the asymmetric price effects of S&P 500 Index additions and deletions.

According to Biktimirov, Cowan, and Jordan (2004), the inability of these prior studies to differentiate conclusively among the competing theories lies in the use of small sample sizes and other compounding issues. In an attempt to better differentiate among these competing explanations by enlarging the sample size, they examine the effect of index changes to the Russell 2000 Index from 1991 to 2000. As a consequence of using this index, Biktimirov, Cowan, and Jordan (2004) find significant, temporary increases (decreases) in price and volume for additions to (deletions from) the Russell 2000 Index, thus supporting the price pressure hypothesis.

In an attempt to reconcile the results of these two studies, we propose examining an index that captures the essence of both the S&P 500 Index and the Russell 2000 Index: the S&P 600 SmallCap Index. Utilizing the S&P 600 Index is advantageous for several reasons. First, the S&P 600 Index, like the Russell 2000 Index, is designed for tracking the performance of small capitalization stocks. According to Standards & Poor's:

The S&P SmallCap 600 is fast becoming the preferred small-cap index in the U.S., covering approximately 3% of the U.S. equities market. Measuring a segment of the market that is typically renowned for poor trading liquidity and financial instability, the S&P SmallCap 600 is designed to be an efficient portfolio of companies that meet specific inclusion criteria to ensure that they are investable and financially viable. As a result, the S&P SmallCap 600 is gaining wide acceptance as the benchmark of choice for both active and passive management.2

The Russell 2000 covers 2,000 companies comprising approximately 8 percent of total market capitalization, while the S&P 600 constitutes approximately 3 percent of total market capitalization. The average and median capitalization of firms in the two indices are similar.3

second, changes to the S&P 600 Index are made in the same manner as changes to the S&P 500. Changes to S&P Indices are based on screening criteria including liquidity and financial viability. The S&P Index Committee monitors the various S&P indices components on a continual basis, making decisions concerning which stocks should be removed from, or added to, a particular index. In contrast, the components of the Russell 2000 index are reconstituted on an annual basis based entirely on market capitalization. Changes to the Russell 2000 are made simply because the relative market value of the firm grew or shrank.

In addition, Standard & Poor's pre-announces its index changes. Thus, an announcement effect exists as the period between announcement day and effective change day varies from one day to about one month, hi contrast, the Russell 2000 constituents are formulated based on their market value on May 31 each year; however, reconstitution of the index does not occur until June 30, a month after the members are determined. Thus, there is no potential announcement effect on the reconstitution day because changes are known. Consequently, it is arguable that given the differences in methodology, the selection of a stock to or from the S&P 600 signals information to the investing public that is not signaled by inclusion in the Russell 2000.

Only a few studies have focused on the stock price effects of changes to an index comprising small capitalization stocks. Prudential securities' analysts report that stocks added to the S&P 600 SmallCap Index in 1996 had positive average returns of 2.11 percent and that stocks moving from the S&P 600 to the S&P 400 increase on average 5.42 percent in value from the time of the announcement until the new listing (Napach, 1997). Bos (2000) looks at 403 additions to the S&P 600 index from its inception hi 1994 through 1999. He finds that the average adjusted return from the announcement date to the effective change date is 5.40 percent, and from the effective change date to ten days after is -2.73 percent. Neither the Napach (1997) report nor the Bos (2000) study examine deletions from the S&P 600 Index, nor do they present any theoretical context or statistical findings.