On the 4th of March 2015, the FTSE Group published the FTSE UK Index Series Quarterly review that announced the entrance of Hikma Pharmaceuticals (HIK) into the FTSE 100 index and the exit of Tullow Oil (TLW) that will thus join the FTSE 250 index. Additional amendments regard the FTSE 250 index, joined also by AA, Imagination Technologies Group and Virgin Money Holdings and left by Afren, Game Digital and Oxford Instruments.

The changes will be implemented after the close of the market on the 20th of March and they will take effect from the start of the trading on the 22nd of March. Hikma’s entrance will allow the pharmaceutical sector to increase its weight in the FTSE 100. This event will place Hikma alongside GlaxoSmithKline, AstraZeneca and Shire as the fourth blue-chip drugmaker of the UK market. Conversely, the exit of Tullow Oil was mainly caused by the decline in oil prices. But this company is not the only one affected by oil’s negative trend. Also Afren, leaving the FTSE 250, experienced an evident decrease in its value. On the 4th March 2015, the oil and gas explorer has seen its shares sinking almost 27 per cent after it defaulted on a $15m interest payment. As a consequence of this drop, the company was set to fall out of the FTSE 250.

The changes to the composition of the index are, as always, aimed at better portraying the market the index represents; more in particular, the FTSE 100 comprises the 100 most capitalized companies listed at the London Stock Exchange and the FTSE 250 the following 250. Looking at historical data, generally the stocks that are announced to enter into the FTSE 100, after a generally positive performance in the days before the announcement, experience a drop in value in the days following it; this is probably linked to the fact that often the companies entering into the index at a certain date were among the reserves published in the previous review. Therefore, at the moment of the announcement the market has already priced in the likelihood of addition.

It is exactly after this initial drop however that the rally starts: some days before the changes are implemented, the price of the stocks that will be inserted starts to increase, peaking with a statistically significant positive change from the closing price of the Friday at the end of which the changes are implemented, to the end of the trading session of the Monday on which the changes take effect. The stocks that instead leave the index show a decrease in price starting before the announcement of their exit and generally prolonging also afterwards. This is exactly what happened after the previous review of the FTSE 100 published on the 4th of December that announced the entrance of Barratt Developments and Taylor Wimpley (the latter was already appearing on the 4th of June among the possible reserves) and the exit of IMI and Petrofac. Barratt Developments closed on the 4th of December at £469.300, falling in the course of eleven days to £434.700 (-7.9%) and then rallying up to £465.900 (+7.1%) at the end of the 22nd of December, first trading day on which the changes took effect. Barratt only provides an example of price move, but similar behaviour have been observed in large sample by researchers.

This phenomenon is even more relevant for Asia where markets are more volatile and following the announcement of the entrance into the FTSE Hong Kong index stocks could rally up to 15%-20% until the actual rebalance occurs. It’s worth noticing that the absence of the reserve list in the full review report of FTSE Hong Kong makes the prediction of the next entrants more difficult, often catching the market by surprise; the stocks in this way start rallying straight after the announcement of their (almost unexpected) inclusion.

The general explanation for this phenomenon has to do with passive strategies. Basically, fund managers who are only interested in mimicking an index cause these stocks to outperform. They spot as main benchmark a particular group of stocks and therefore their performance is assessed in relation to this conglomerate. Consequently, they try to replicate the weight every company has in the group.

Anyway, this strategy can be implemented both by exactly replicating the index and by mimicking its main features, as the weights of the different sectors. Consequently, changes in the composition of the index force managers to modify their portfolios. The change should trigger an evident sell-off of the exiting company and, at the same time, an important increase in the demand of the new stocks joining the group. Coherently with this reasoning and backed by data, a possible trading idea would be going long on the latter (some days before the changes are implemented) and simultaneously going short on the former, adjusting for the Beta of the stocks.

(On the 6th of March Apple was announced to enter the Dow Jones Industrial Average, $1 Trillion valuation getting closer for the largest company in corporate history?)

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