Evidence from the CSI 300 Index Additions and Deletions
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Asymmetric Responses to Stock Index Reconstitutions: Evidence from the CSI 300 Index Additions and Deletions Ching-Ting Lina,* a Department of Money and Banking, National Chengchi University, 64, Sec. 2, Zhi-Nan Road, Wenshan District, Taipei 11605, Taiwan R.O.C. Wei-Kuang Chenb,† b Department of Money and Banking and Risk and Insurance Research Center, National Chengchi University, 64, Sec. 2, Zhi-Nan Road, Wenshan District, Taipei 11605, Taiwan R.O.C. *Corresponding author. Tel: 886-2-2939-3091ext.81248. Email: [email protected]. †Tel: 886-2-2939-3091ext.81220. Email: [email protected]. Asymmetric Reponses to Stock Index Reconstitutions: Evidence from the CSI 300 Index Additions and Deletions Abstract This study investigates constituent changes to the CSI 300 index, which is scheduled semiannually in accordance with clearly-stated selection methodology. We find that stocks experience a permanent price increase and receive optimistic EPS forecasts from analysts following their addition to the index. These optimistic earnings expectations are supported by increased capital-raising activities and capital expenditure. Conversely, we do not find any significant results for index deletions. Evidence in the form of changes in the number of shareholders and shadow costs are consistent with the investor awareness theory. Increased investor awareness and monitoring forces newly-added firms to perform effectively, resulting in the attraction of more newly-issued capital from investors due to the firms’ lower cost of capital. Monitoring and management efficiency, however, would not lessen sharply for deletions. JEL Classification: G12, G14, G20. Keywords: CSI 300 index; stock index reconstitution; investor awareness; analyst EPS forecast; capital expenditure; asymmetric market response. 1. Introduction China’s equity markets have developed tremendously since the Shanghai Stock Exchange and the Shenzhen Stock Exchange were launched in 1990. The total market capitalization was more than USD 6 trillion at the end of 2014, ranked as the second largest in the world.1 The CSI 300 index was launched on April 8, 2005 and is composed of the 300 largest and most liquid A-shares listed on the two stock exchanges. The CSI 300 index has been used as the basis for many financial products around the world and is also used by investors to develop and benchmark their portfolios.2 The CSI 300 index reconstitution methodology is relatively transparent, in contrast with the S&P 500 and MSCI indices. For example, changes to the S&P 500 index are made on an as-needed basis. Market capitalization, liquidity, public float, and many other factors determine the constituents of the S&P 500 index, but the selection methodology is not clearly-stated to the public. As for the MSCI indices, MSCI implements regular semiannual and quarterly reviews, but does not target any specific number of firms. This means that a deletion from one of the MSCI indices does not guarantee a corresponding addition to that index. In other words, additions and deletions in the MSCI indices are not symmetrical, and as such reconstitutions of the MSCI indices are not predictable. By contrast, reconstitutions for the CSI 300 index are regular and made in accordance with a clearly-stated selection methodology. The components of the CSI 300 index are reviewed twice a year in June and December. Determined by the ranking of market capitalization and liquidity, the largest and the most liquid 300 stocks are selected as the index components. Any component adjustment is effective on the first trading day in July and January. With a regular review schedule and clearly-stated selection methodology, the change of index constituents could be predictable and the abnormal returns for newly-added stocks 1 At the same year end, the market capitalization of NYSE stood at USD 19 trillion, the Tokyo Stock Exchange comprised USD 4.38 trillion and the Hong Kong Exchanges stood at USD 3.23 trillion. Market capitalization in other emerging markets was USD 1.21 trillion in the Korea Exchange, USD 1.52 trillion in the National Stock Exchange in India, and USD 0.08 trillion in the Taiwan Stock Exchange. 2 There are 22 exchange traded funds (ETFs), 31 index funds, and 2 feeder funds based on the CSI 300 index. The total assets of the ETFs trading the CSI 300 index are estimated around $89.96 billion globally. More than $19.10 billion in fund assets are estimated to be benchmarked to the CSI 300 index. The CSI 300 index futures launched on April 16, 2010. According to data retrieved from Thomson Reuters, they already surpassed the S&P 500 futures in terms of turnover. 1 around the announcement date should be smaller than those found in the literature pertaining to the S&P 500 and MSCI indices. However, we find that stocks experience a permanent price increase post- addition. The average announcement date abnormal return is a significantly positive 0.45%. The cumulative excess returns from the announcement date to the effective date, 20 days after the effective date, and 60 days after the effective date are 1.17%, 1.53%, and 2.97%, respectively. By contrast, there is only a weak abnormal return decrease post-deletion. Deleted firms have a temporary price decrease initially, but this loss is then recouped in the long run. The asymmetric response to reconstitutions is in line with findings documented by Chen et al. (2004), who propose that investor awareness is the main driver of asymmetric response for stock index reconstitutions. Investor awareness increases post-addition. However, investors do not neglect deleted firms immediately so that investor awareness does not decline immediately post- deletion. We conduct tests on changes in the number of shareholders and shadow cost, and our empirical results are consistent with the view of the investor awareness hypothesis. If the investor awareness hypothesis is held to be true, additions to the index would attract more investors, who would exert pressure on the added firms to improve their performance (Denis et al., 2003). With better corporate governance, firms are expected to lower their cost of capital and attract more newly issued capital from investors. By contrast, investors do not neglect deleted firms immediately, so investor monitoring and capital should exhibit a weak change post-deletion. Following Denis et al. (2003), we use analysts’ EPS forecasts as a proxy to capture changes in earnings expectations. Findings in this paper show that firms added to the CSI 300 index receive optimistic EPS forecasts. Analysts systematically revise their earnings forecasts upwards post-addition. Conversely, we don’t find any significant change for firms that have been deleted from the CSI 300 index. Results are in line with evidence from Denis et al. (2003) and Chen et al. (2004) that reconstitutions are not information-free and market response is asymmetric for additions and deletions due to changes in investor awareness. The next question concerns whether added firms improve management efficiency due to increased investors awareness. We use capital-raising activities and capital expenditure as proxies to examine if reconstitutions have any impact on management 2 efficiency. To our best knowledge, this is the first paper using capital expenditure to provide a direct examination of changes in firms’ management efficiency for stock index reconstitutions. The evidence shows that firms that are newly added to the index conduct more capital-raising activities, especially debt financing. The increased capital-raising activities lead to the expansion of capital expenditure, as hypothesized. For deletions, on the other hand, the changes in capital-raising activities and capital expenditure are mild and insignificant. In contrast to Li et al. (2009), who indicate that increases in capital expenditure destroy firm value, we find that increases in capital expenditure can drive up firm value and result in improved earnings forecasts by financial analysts. This paper contributes to our understanding of at least two aspects of stock index reconstitutions. First, existing theories on the price effects of stock index reconstitutions are mixed. Harris and Gurel (1986) propose the price pressure hypothesis and indicate that price change is temporary, which is supported by Mase (2007), Biktimirov and Li (2014), and others. On the contrary, Shleifer (1986) indicates that stocks have a long-term downward sloping demand curve so that price change is permanent, which is confirmed in several subsequent studies (Beneish and Whaley, 1996; Lynch and Mendenhall, 1997; Wurgler and Zhuravskaya, 2002; Yun and Kim, 2010). Chen et al. (2004), departing from the previous literature, find an asymmetric market response to reconstitutions and attribute this phenomenon to investor awareness. Most prior empirical studies on stock index reconstitutions, however, focus on indices in developed countries (Biktimirov and Li, 2014; Chen et al., 2004; Denis et al., 2003; Harris and Gurel, 1986; Liu, 2006, 2000; Lynch and Mendenhall, 1997; Mase, 2007) rather than emerging markets. Reconstitutions for major indices (e.g., the S&P 500) do not have a regular review schedule or clearly- stated selection criteria. Component changes for those indices may contain publicly unavailable information. This paper contributes to the literature on market response to reconstitutions in the top bourses in emerging markets. The data used in this work includes a complete list of constituent changes from the inception of the CSI 300 index to the most recent review. The CSI 300 index reconstitution is scheduled semiannually by clearly-stated selection methodology so that the settings for the CSI 300 index reconstitutions should have the least information content, which provides an alternative way to examine price impact on constituent changes. Similar to the 3 results from Chen et al. (2004), we find that stocks experience a permanent price increase post-addition and a weak decrease post-deletion. These results are in line with the investor awareness theory.