The S&P inclusion effect is a well known technical effect that traders have benefitted from for years. The logic is very simple: every quarter, announced usually on the 20th before the end of the quarter, stocks are dropped and added to the S&P 500.

This seemingly benign exercise provides opportunities for traders and smaller investors in the sense that, the shares that are added get a temporary boost while those that are dropped experience a temporary decline. The reason for this is that the S&P 500 is one of the most, if not the most, popular index in the entire world with $10 trillion in funds linked to it. It covers the 500 largest companies by market cap that are based in the US and is regarded as a gauge for the US stock market and the economy in general.

It has grown in importance after years of investors having shifted from actively managed mutual funds to passively managed mutual funds and ETF’s. All this institutional money chasing the index is what makes the quarterly adjustments to the index a profitable opportunity for some traders. Once a company is included in the index, large institutional buyers will have to purchase the stock in order to reflect it in their fund which tracks the index. This forced buying by these investors is what has spurred some to buy up the stocks they think will be included ahead of time in anticipation for this.

The Selection Method

Say you are the adventurous type and would like to try your hand at this strategy, now is as good a time as ever. With all the volatility since the pandemic started to take hold, as much as 20% of the companies in the S&P 500 no longer fit the criteria to remain in the index. That is, if you are sticking to the explicit published rules. These rules state that a company needs to have a profit in the most recent quarter, the sum of the previous 4 quarters profit cannot be negative, at least 50% of the shares must be available to the public and the market cap must be at least $8.2 billion. Companies may violate these minimums once within the index but may be removed by committee if they violate many of them over time.

The committee debates each quarter on what names should be added or deleted so there is some wiggle room for each company, depending on its story. Some though, are obvious cases to be dropped. On the other hand, there are many stocks on the upswing in the mid cap index that are likely to be included. This committee strategy for inclusion gives S&P flexibility in times of crisis. For example in 2009 during the height of the crisis, AIG was allowed to remain despite the government owning more than 50%. Crucially for AIG, this kept the shares liquid and AIG was able to eventually pay back the government funds.

Exceptions to the Rule

There are also some exceptions to the rule that may keep certain names out. One notable trend that I have been commenting on for the last year, is that mega cap tech companies have been dominating stock market performance for the past 5 years. Tech companies are represented in the S&P 500 to a point not seen since the dot com bubble and this time the composition is different.

Source: S&P, as of April 30, 2020

The differentiating factor this time is that the FAANG make up most of the gains and dominate revenue, valuations and earnings. This isn’t luck, it’s part of a growing secular trend of further consolidation of large companies in the US through a combination of mergers, acquisitions and crushing upstart competition. The pandemic has just further consolidated market position for many of these names. Amazon looks to be a big winner with more people staying home and their services becoming even more critical for people’s day to day survival.

This is also why the S&P 500, with its large cap focus has pulled away from indexes that emphasize small or mid caps in recent years. Looking back 2 years and taking into account the upsurge since April, the S&P is up almost 9% while indexes like the Russel 2000 and the S&P 600 small cap index are both down approximately 23% and 29% respectively.

Source: Yahoo Finance

So the committee may have some hesitation in terms of adding even more tech companies to the mix.

Another factor to consider is that many companies experienced a loss in the first quarter with the lockdown coming in the first part of May. Add to that, some sectors like hospitality and retail have been more severely impacted by the lockdown so sticking blindly to the rules now may take entire sectors almost completely out of the index, which the committee may want to avoid. You can’t deny that certain areas are in deep trouble though. We may see some cruise lines lose their listing as well as some of the retailers that are in a tailspin due to the lockdown.

The List

Taking these points and the basic criteria into account, I decided to look at stats for all the stocks listed in the S&P 500 as well as the S&P 400 mid cap to see which stocks were likely to be included as well as which were likely to be dropped.

Those that may be added include:

• West Pharmaceutical Services (WST)
• Interactive Brokers (IBKR)
• Domino’s Pizza (DPZ)
• Bio-Rad Laboratories (BIO)
• Masimo Corp. (MASI)

These companies have market caps that are more than 5 times of some of the smallest stocks in the S&P 500 and have recent profitability as well as a sufficient public market float. West Pharmaceutical Services is an interesting play as it manufactures components for injectable drug delivery and plastic packaging. A logistics service targeting the healthcare industry in a pandemic sounds like the perfect recipe for growth, one reason it may have jumped 68% since the recent market bottom in March.

On the flip side, a number of names seem sure to drop out of the S&P 500:

• L Brands (LB)
• Under Armor (UAA)
• Coty Inc. (COTY)
• Helmerich &Payne Inc. (HP)
• Norwegian Cruise Line Holdings Ltd. (NCLH)

Norwegian probably isn’t a surprise but L Brands includes the iconic brands Victoria’s Secret as well as Bath & Body Works which both have struggled as of late.

How to Profit

The easiest way to profit would be to try and go long by purchasing the stocks of names set to be included in the index. Another option would be to go long those stocks but also short the names that are likely to leave the index.

If there are options that can be purchased on these and you don’t have as much capital, an even more aggressive approach would be to purchase options on those about to enter the index as well as puts on those about to leave

It’s worth noting that there has been some research that says the S&P inclusion effect has disappeared. This report from the Fed found that there was no long term boost in a stock’s price due to inclusion in the index. The key phrase here is long term. Other studies show that there is indeed a short term bump to stock prices for those stocks which are added and a short term fall for those that are dropped. This is exactly the type of predicable systematic movement that traders look for.

Keep it in Perspective

As always, a strategy like this should be done in the context of your entire portfolio. For active investors who want to stay engaged like myself, I recommend the core-satellite approach to your portfolio. This consists of the majority of your portfolio being in diversified index funds which track the wider markets, then dedicating 5% to 10% of your portfolio to swing for the fences and try new and exciting strategies to try and pad your returns.

It is likely you won’t be successful long term and even if the strategy described above is successful overall, it isn’t very tax efficient as it will be taxed at the short term rate.

There is something to be said about the advantages you have as a small investor though. Small investors have the advantages of being able to take large position in companies that are not followed by professional analysts and the financial industry at large. This allows them to take advantage of information inefficiencies that may not exist for large cap stocks. It also allows them to profit more from the inclusion effect. The smallest stock in the S&P 500 represents about 0.006% of the entire index. It’s so small that throwing a few million at it is pittance to the largest funds. The profit made from trying to benefit from the inclusion effect for a large fund is so insignificant compared to the hundreds of billions it manages that it isn’t even worth it to try. It pays to know your place within the market and also be able to benefit from it.

The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.