GB792 Unit 10 Finance Research Paper Example

A Smaller Shock, Not a Flatter Curve: A Unit 10 Finance Research Paper on the Disappearing Index Effect

[Student Name]

Purdue University Global

GB792: Advanced Topics in Finance

Unit 10 Finance Research Paper

[Instructor Name]

[Date]

The paper's argument and proposed test are the candidate's; the studies and figures cited are from real published research.

Abstract

When a stock is added to the S&P 500, funds that track the index must buy it. If the demand curve for a stock slopes downward, that forced buying should raise its price, and for decades it did. Greenwood and Sammon (2025) document that the average abnormal return on announcement fell from 3.4 percent in the 1980s and 7.6 percent in the 1990s to 0.8 percent between 2010 and 2020, while the share of market assets linked to the index rose. This paper argues that the decline is better explained by a smaller and more anticipated net demand shock than by more elastic demand. It reviews the evidence, states the opposing interpretation and proposes a test that would separate them.

Introduction

The index effect has been one of the cleanest pieces of evidence in finance that prices respond to demand unrelated to information. Inclusion in the S&P 500 is decided by a committee using published criteria, and in principle it says nothing new about a company's cash flows. If prices rise on inclusion, the rise reflects the buying it triggers, which contradicts the textbook view that each stock has close substitutes and therefore faces nearly flat demand.

The disappearance of the effect seems to suggest that the textbook view has become true: markets now absorb even large, predictable demand without moving prices. This paper argues that such a reading is premature. The forced buying that inclusion triggers is not what it was, both because many additions now arrive from another index whose funds must sell at the same moment, and because traders buy ahead of announcements they can predict. A smaller and earlier shock would produce a smaller announcement return even if the demand curve had not changed at all.

The Theory

In a market where every stock has perfect substitutes, a demand shock unrelated to information should not move prices, since arbitrageurs would sell the stock and buy its substitutes until any price gap closed. If substitutes are imperfect, or arbitrage is costly and risky, the demand curve slopes downward, and a large purchase raises the price. The index effect tests between these views by providing a demand shock whose size can be estimated and whose timing is known.

The size of the price response depends on two things: the slope of the demand curve and the size of the net demand shock that reaches the market at the moment being measured. A smaller response can come from either. The literature on the index effect has largely treated the shock as known and drawn conclusions about the slope. The argument here is that the shock itself has changed.

The Evidence Before the Decline

Shleifer (1986) found that stocks added to the S&P 500 after September 1976, when index funds began to grow, earned significant positive abnormal returns on announcement that did not disappear for at least ten days, and that the returns were related to measures of index fund buying. He interpreted this as evidence that demand curves for stocks slope down. Harris and Gurel (1986) found price increases at inclusion that partly reversed afterward, which they read as temporary price pressure from the buying.

Two later studies sharpened the case. Kaul et al. (2000) studied a change in the weights of the Toronto Stock Exchange 300 index that altered index demand for some stocks without conveying information about them. Prices of affected stocks rose, and the increase did not reverse, which they took as evidence of downward-sloping demand. Chen et al. (2004) found that additions to the S&P 500 produced a permanent price increase while deletions produced no permanent decline, an asymmetry they attributed to changes in investor awareness, since inclusion draws attention that deletion does not withdraw.

The Decline

Greenwood and Sammon (2025) documented the decline across four decades. The announcement return on additions fell from its peak in the 1990s to under 1 percent in the 2010s, and the negative return on deletions fell from large losses to about minus 0.6 percent. Over the same years, index funds and other investors tied to the S&P 500 held a growing share of the market, so the forced buying from inclusion, measured simply as the index-linked share of a stock's shares, should have grown.

They examined several explanations. One is index migration. Many stocks added to the S&P 500 now come from the S&P MidCap 400, and when a stock moves up, funds tracking the MidCap must sell it at the same moment that S&P 500 funds buy. The share of additions that were migrations rose from about half in the 1990s to more than 70 percent in recent years. A second is anticipation. Additions have become more predictable, and sophisticated traders buy likely additions before they are announced, so part of the price effect occurs before the announcement date that studies measure. A third is improvements in market liquidity, which would make prices more resilient to any given purchase.

A demand curve's slope can only be measured against a shock of known size, and the size of the inclusion shock has been falling for thirty years.

The Argument

Two of these explanations, migration and anticipation, concern the shock, and only the third concerns the slope. The paper's argument is that the first two can account for much of the decline without requiring the third.

Migration reduces the net demand shock directly. If a stock leaves the MidCap index as it enters the S&P 500, the buying from one set of funds is partly offset by selling from another. The net buying, the quantity that matters for price, can be much smaller than the gross figure suggests. A stock added from outside both indexes faces the full shock; a migrating stock faces only the difference.

Anticipation moves the shock in time. If traders buy predicted additions before the announcement and sell to index funds afterward, the price adjusts before the date researchers treat as the event. The announcement return then understates the total price effect, and the demand curve need not have flattened.

The Opposing Interpretation

The strongest opposing view is that markets have become more elastic. Trading costs have fallen, arbitrage capital has grown and exchange-traded funds offer close substitutes for many stocks. On this view, a given demand shock moves prices less today because more capital stands ready to absorb it. Greenwood and Sammon's finding that the decline occurred as index ownership rose seems to support this: if the shock grew while the response shrank, the slope must have flattened.

This view has force, and the paper does not claim that liquidity played no role. But the inference depends on measuring the shock as gross index ownership. If the net shock fell because of migration, and the timing moved because of anticipation, the evidence is consistent with a demand curve that has flattened somewhat or not at all.

A Proposed Test

The two interpretations can be separated. For each addition, the net demand shock can be estimated as the shares S&P 500 funds must buy minus the shares MidCap funds must sell, scaled by shares outstanding. Returns can then be measured over a window long enough to capture anticipation, such as from the date an addition becomes predictable from published criteria to several days after the effective date. If the price response per unit of net demand has fallen over time, the slope has flattened. If it has stayed roughly constant while the net shock fell, the slope has not changed and the decline reflects the shock. Additions from outside both indexes, where the net and gross shocks coincide, provide a direct check.

Limitations

The argument relies on estimates of index fund holdings that are imperfect, since many investors benchmark to the index without being required to hold it. The window for anticipation is difficult to define precisely. And the decline may reflect all three explanations in combination, so that the proposed test could find partial flattening alongside a smaller shock. The paper's claim is narrower than that demand curves have not changed: it is that the disappearing announcement return, by itself, does not show that they have.

References

Chen, H., Noronha, G., & Singal, V. (2004). The price response to S&P 500 index additions and deletions: Evidence of asymmetry and a new explanation. The Journal of Finance, 59(4), 1901-1930. https://doi.org/10.1111/j.1540-6261.2004.00683.x

Greenwood, R., & Sammon, M. (2025). The disappearing index effect. The Journal of Finance, 80(2), 657-698. https://doi.org/10.1111/jofi.13410

Harris, L., & Gurel, E. (1986). Price and volume effects associated with changes in the S&P 500 list: New evidence for the existence of price pressures. The Journal of Finance, 41(4), 815-829. https://doi.org/10.1111/j.1540-6261.1986.tb04550.x

Kaul, A., Mehrotra, V., & Morck, R. (2000). Demand curves for stocks do slope down: New evidence from an index weights adjustment. The Journal of Finance, 55(2), 893-912. https://doi.org/10.1111/0022-1082.00230

Shleifer, A. (1986). Do demand curves for stocks slope down? The Journal of Finance, 41(3), 579-590. https://doi.org/10.1111/j.1540-6261.1986.tb04518.x