Institutional trading and security prices: the case of changes in the composition of the S&P 500 index

This paper examines the common stock valuation and liquidity effects of firms being added to and deleted from the S&P 500 Index. Three potential pricing and trading volume hypotheses are discussed and tested–an Information Content Hypothesis (ICH), a Price Pressure Hypothesis (PPH), and a Liquidity Cost Hypothesis (LCH). The empirical findings indicate that firms being added to (deleted from) the S&P 500 Index over the 1977 to 1983 period experience positive (negative) abnormal common stock returns on the day following the addition. An analysis of common stock liquidity around additions to the Index reveals that while relative trading activity increases in the month of addition, it actually declines in subsequent months. The valuation and liquidity results are consistent to some degree with both the PPH and the LCH and are most likely due to index fund managers adjusting their holdings to reflect changes in the Index.