Side Effects
By Hilary Till

The price-pressure effects of index investments in the global stock markets are well-documented. And even when these effects are so well-known, they show no sign of diminishing. Are other asset class-es similarly affected by indexing? The short answer is yes: Commodity investing also incurs price-pressure effects caused by the prevalence of indexed-based investments. This article begins by summarizing the index effect in the equity markets, which has been widely published in both the popular financial press and in academic papers. Next comes a study that shows similar effects can be found in the commodity mar-kets. It concludes with a preliminary model  for explaining the magnitude of the index effect on commodity futures markets. Don't worry: Some of the arcane aspects of com-modity  futures markets will be explained so that this article can be generally understood.

Indexing's Impact In Equities

The 'index effect' usually refers 'to the impact on stocks that are added to or removed from the S&P 500,' notes Bary [1998]. '[It] is so strong these days because of the growing popularity of indexed invest-ing and the rising number of 'closet index-ers, 'institutions whose holdings closely match the benchmark portfolio.

'As of 1998, 8% of the market value of all stocks in the S&P 500 is held by indexed portfolios, according to Bary [1998]. 'When a new company comes into the S&P, indexers need to buy 8% of its shares. Unlike most investors, indexers are price-insensitive. Many simply want to buy at the close of trading on the day a company is added to the S&P.'In Bary [1999], the financial columnist adds that 'the index effect can be severe because many index funds simply want to buy a stock at the NYSE closing price on the day the company is added to the S&P and often don't care what they pay as long as the price they receive is the NYSE close.'

The index effect actually was first docu-mented in an academic study in 1986. Harris and Gurel [1986] reviewed the price and vol-ume effects resulting from changes in the S&P 500. They found that 'immediately after an addition [to the S&P 500] is announced, prices [in the added stock] increase by more than 3 percent. This increase is [then] near-ly fully reversed after two weeks.'

Fifteen years after this academic study, the index effect not only has continued to exist but it also is even more dramatic than when it first was documented. This is probably because of the increased popularity of index-based investment since that time. A Business Week article in early 1999 queried, 'Who Needs a Money Manager?'After all, 'index funds are cheap, easy-- and they're chang-ing the way Americans invest.'The article reported, 'Last year, index funds attracted $42 billion, or 19% of the money committed to mutual funds, according to Financial Research Corp. That number has nearly dou-bled since 1996 & 'The article later asserted, 'When Standard & Poor's Corp. & puts new stocks in the index, the additions see their prices jump an average of 7%.'

Bary [1999] also pointed out the intensify-ing index effect. 'Merrill Lynch quantitative analysts have shown that companies added to the S&P 500 in 1998 enjoyed greater appreciation in the days leading up to their inclusion in the index than new entrants did in previous years. The flip side is that the ' 98 newcomers tended to fall more sharply after joining the S&P.'

The index effect is not just an American stock market phenomenon. In 1999, The Financial Times carried a number of articles on the index effect occurring in stocks in both the French and U.K. markets due to additions and deletions to their respective market indexes.

Changes to the Morgan Stanley Capital International [MSCI] family of  international equity indexes reportedly have had dramat-ic impacts on national stock markets. The Wall Street Journal [1999] noted, 'the announcement that & [the MSCI indexes] would reinstate Malaysia and boost Taiwan's weighting & sent stocks in those countries soaring.& the Kuala Lumpur composite index soared 6%, while Taiwanese stocks jumped 4%.'

It may even be the case that the equity-index effect can have a temporary effect on the value of currencies. Bear Stearns [1999]  noted in a morning commentary, 'yen strength was the main story. As Europe opened, EUR/JPY made a fresh lifetime low & The main reason appears to have been Morgan Stanley's decision to increase their weighting of Japanese stocks & [with respect to] Euro stocks on their MSCI.'

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