Is index inclusion all it’s cracked up to be?

Investing.com -- The inclusion of a company in a major stock index like the S&P 500 is often seen as a hallmark of success, signaling to the market that the company has achieved a certain level of financial stability and growth.

However, analysts at Strategas Securities in a note suggest that the reality may not be as straightforward as it appears.

One of the most compelling findings from the Strategas Securities analysis is the stark difference in performance of companies leading up to their inclusion in the S&P 500 compared to their performance afterward.

The study examined 160 companies that were added to the S&P 500 between 2015 and 2024. “On average, the names outperformed the S&P 500 by +4800 bps, just mildly better than the -66 bps of underperformance exuded 12 months post inclusion as noted in the prior point,” said analysts from Strategas Securities.

This outperformance could be attributed to the "buy the rumor" phenomenon, where investors anticipate a company's inclusion in the index and drive up its stock price in the months preceding the official announcement.

The inclusion itself is often seen as a validation of a company’s growth and stability, leading to heightened investor interest and, consequently, a surge in stock price.

However, the picture changes dramatically after inclusion. The same study found that in the 12 months following their inclusion, these new constituents underperformed the broader index by an average of 66 bps​.

This underperformance is surprising, especially considering that companies usually need to demonstrate improving fundamentals to meet the eligibility requirements for index inclusion.

The post-inclusion underperformance raises questions about the long-term benefits of being added to a major index. It suggests that much of the positive impact of inclusion is already priced in by the time the inclusion occurs.

Moreover, the surge in stock price leading up to inclusion might lead to overvaluation, making it difficult for the stock to sustain its performance afterward.

The analysis also explored the performance of companies that were removed from the S&P 500, excluding those that were acquired. “On average, these names underperform the index by ~-825 bps in the 12 months after their exit,” the analysts said.

This is not entirely unexpected, as removal from the index often reflects a deterioration in a company’s fundamentals, which typically continues post-exit.

Investing in an index does not guarantee sustained outperformance, as Strategas Securities explains. The phenomenon of "buy the rumor, sell the inclusion" seems to be at play, where the market reaction to anticipated inclusion is far more positive than the actual benefits of inclusion itself.

For long-term investors, this suggests a need for caution and a more nuanced approach when evaluating the impact of index inclusion on a stock’s future performance.

Additionally, the underperformance of companies post-exit underscores the importance of maintaining strong fundamentals.

While inclusion in a major index can provide a short-term boost, companies need to continue demonstrating robust financial health to sustain long-term success.

This article first appeared in Investing.com