Explain how an index picks and weights its members, and why being added to one moves a stock's price.
A stock can rise in price because it is joining an index, even when its customers, margins and debts have not changed. The price moves because of who now has to buy the shares, and not because of any news about the business.
Marcus holds Larkspur, a small supplier listed on SGX. One evening an index provider announces that Larkspur will join a regional small-cap index at the next review. The next morning Larkspur shares open 6% higher (an example figure), though its customers, margins and debts are the same as the day before.
Lesson 2.1 of the course Build and run an ETF portfolio, "What an index is and how it decides weights", covers the same index rules from the buyer's side. Seen from the side of a stock inside an index, those rules decide how much weight the stock gets, when index funds must buy it and how much they must buy.
Most major indexes weight their members by free-float market value. This is the share price times the shares available to trade. It leaves out blocks held by founders, governments, parent companies and other long-term holders. The shares left to trade are the free float. The index weights each member by this float-adjusted value and does not use full market value.
You can work out Larkspur's float-adjusted value in three steps. First, find full market value by multiplying total shares by the share price. Larkspur has 300 million shares at S$1.60, so 300 million x S$1.60 = S$480 million. Second, subtract the shares held by long-term holders to get the free float. The founding family owns 55% and never trades, which leaves a free float of 45%, or 135 million shares. Third, multiply the free-float shares by the share price: 135 million x S$1.60 = S$216 million, which is less than half the headline figure. The index weights Larkspur on that S$216 million.
Free float explains why some large Singapore companies carry less index weight than their market value suggests. It also means a company can gain index weight without its price moving. If a big holder sells a block to the public, the float rises and the weight rises with it. Indexes differ in how they treat foreign ownership limits, multiple share classes and very large single holdings, and the methodology document spells out each rule. Because weighting is based on free float, an index fund never has to buy shares that do not trade, and this keeps the index investable.
Index membership follows published rules, usually on size, liquidity and float. A company must be big enough, trade often enough and have enough shares in public hands. Some indexes add other tests. The S&P 500 is chosen by a committee and requires a record of positive earnings, so a large loss-making US company can stay outside it for years. The STI (Straits Times Index) tracks 30 large Singapore companies. FTSE Russell calculates it under published ground rules covering eligibility, liquidity tests and review frequency.
Each provider sets out its rules in a methodology document, sometimes called the ground rules. It covers eligibility, weighting, liquidity tests, review frequency and how far ahead changes are announced. Most providers review on a fixed schedule and announce changes some days or weeks before the change date, so the market knows what is coming.
Prices move in the gap between the announcement and the change date. An index-tracking fund must hold a new member at its index weight by the time the change takes effect, because buying later risks lagging the index. Most of this buying happens near the close on the last day before the change, at the closing auction. Lesson 5.2, "Order types beyond limit and market, and when each helps", covers the closing auction.
You can estimate how much the funds need to buy. Suppose the index funds tracking the small-cap index together hold 8% of every member's free float. First, multiply that percentage by the stock's free-float shares: 8% of 135 million is 10.8 million shares. Then divide by the average daily volume to get days of normal trading. Larkspur's average daily volume is 0.6 million shares, so 10.8 million divided by 0.6 million is 18 days of normal trading, which the funds want to buy on one afternoon.
Traders know about this forced buying. They buy between the announcement and the change date and expect to sell to the index funds at the close, so the price tends to rise before the change rather than on the change day itself. Research on index additions has generally found a price effect around inclusion. The size of that effect and how long it lasts have varied by market and period, and much of it has been arbitraged away as more traders watch for it. Deletions work in reverse: index funds must sell, which pushes the price down.
If you hold a stock in Marcus's position, three practical points follow. Do not treat an index-driven price jump as news about the business. Do not assume the jump will last, because the extra buyers are gone after the change date. If you hold a thinly traded stock that is leaving an index, expect weak prices and poor liquidity around the change.
Market-value weighting gives the largest companies the largest weights, and their weights grow as their prices rise without anyone buying more shares. When a handful of companies make up a big share of an index, which is called concentration, an index fund becomes a large bet on those few names. The STI gives large weights to the three local banks, and a world index gives large weights to the biggest US technology companies.
Concentration reflects what the market looks like and is not a flaw in the index. It does change how you count your exposure when you set position limits. Marcus holds Singapore bank shares and an STI ETF, and the two moved together in the correlation matrix from Lesson 2.4, "Beta, correlation and why diversification shrinks in a crisis". He also holds a US chip designer that overlaps with the large US tech weights in a world index. Lesson 11.3, "Position and sector limits, and concentration risk", turns concentration into position limit rules.
Providers publish each index's top ten holdings and their combined weight on a monthly factsheet. Get the latest factsheet for each index you own and check both numbers.
Marcus opened the methodology document for the world index his ETF tracks. In twenty minutes he found four facts:
the selection rules the weighting method how often it rebalances how far ahead changes are announced
Do the same for one index you hold.
Read the published rules for one index you hold. Write down how it picks members, how it weights them and how often it reviews them.
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