ERASMUS UNIVERSITEIT ROTTERDAM ERASMUS SCHOOL OF ECONOMICS MSc Economics and Business Economics Behavioural Finance The effect of index inclusion Author: R. Kaptein Student number: 360633 Supervisor: C. Li Date: May 2016 Abstract Many empirical studies reveal that there is an index inclusion effect: a stock’s inclusion to an index is associated with significant abnormal returns. The effect of the index reviews in the Dutch market has been studied to a limited extent, in particular the differences in index inclusion effect between the large cap, mid cap and small cap indices of the Netherlands have never been studied before. This thesis investigates the index inclusion effect in the Dutch stock market. I found that, for the AEX inclusions an upward price movement of 5.64% is observed during the 50 days before the inclusion. This is followed by a full price reversal: the return on the inclusion day was -0.99% and during the 50 days after the event a cumulative abnormal return of -7.13% was found. The results of the AMX inclusions are in particular interesting, because in contrary to the findings for the AEX inclusions, the observed price changes lead to permanently higher stock prices. When examining the pre-inclusion period of 50 trading days, a strong positive excess return of 9.54% is observed. No reversal is observed during the 50 days after the event. Significant price patterns for index exclusions and AScX reviews were not found. The results are consistent with the trading behaviour of index funds and the anticipation of investors, but can also be linked to other several hypotheses. JEL Classification: G14 Key words: Event study, index review, AEX, AMX, AScX, cumulative abnormal returns, behavioural finance. NON-PLAGIARISM STATEMENT By submitting this thesis the author declares to have written this thesis completely by himself/herself, and not to have used sources or resources other than the ones mentioned. All sources used, quotes and citations that were literally taken from publications, or that were in close accordance with the meaning of those publications, are indicated as such. COPYRIGHT STATEMENT The author has copyright of this thesis, but also acknowledges the intellectual copyright of contributions made by the thesis supervisor, which may include important research ideas and data. Author and thesis supervisor will have made clear agreements about issues such as confidentiality. Electronic versions of the thesis are in principle available for inclusion in any EUR thesis database and repository, such as the Master Thesis Repository of the Erasmus University Rotterdam 2 Table of Contents 1. Introduction 5 2. Literature Review and Hypotheses 6 2.1 Previous findings on the index inclusion effect 6 2.2 Price Pressure Hypothesis versus Downward Sloping Demand Curve Hypothesis 8 2.2 Block Trades 9 2.3 Information Signalling Hypothesis 10 2.4 Liquidity Hypothesis 11 2.5 Anticipating Investors 12 2.6 Selection Bias 13 2.7 Limits to Arbitrage 13 3. Methodology 14 3.1 Event Study 14 3.2 Market Model 14 3.3 Estimation- and Event Window 15 3.4 Datastream Event Study Tool 16 3.5 One Sample T-Test 17 3.6 Wilcoxon One Sample Signed Rank Test 17 4. Data 18 4.1 The Amsterdam Exchange Index 18 4.2 Selection Procedure 18 4.3 Event Dates 19 5. Results 20 5.1 AEX Inclusions 20 5.2 AEX Exclusions 23 5.3 AMX Inclusions 24 5.4 AMX Exclusions 27 5.5 AScX Inclusions 28 5.6 AScX Exclusions 29 6. Conclusion and recommendations for further research 30 6.1 Conclusion 30 6.2 Limitations and recommendations 31 References 32 Appendix 1 34 Appendix 2 35 3 Tables And Figures Figure 1: Event Study 16 Figure 2: Table results AEX inclusions 21 Figure 3: Graph results AEX inclusions around inclusion date 22 Figure 4: Table results AEX exclusions 24 Figure 5: Table results AMX inclusions around inclusion date 25 Figure 6: Graph results AMX inclusions 26 Figure 7: Table results AMX exclusions 28 Figure 8: Table results AScX Inclusions 29 Figure 9: Table results AScX Inclusions 30 4 Chapter 1: Introduction On the 5th of March 2015, Euronext announced its annual review of the AEX, AMX and AScX, publishing the inclusions and exclusions of stocks for these indices. The following day, the stocks that were going to be included in the AEX showed a positive return during the opening hours of the stock exchange. Media explained this positive return by the fact that those stocks will be included in the AEX soon, but no new information regarding the companies’ future prospects was released and thus the fundamental value of these companies did not change. This raises some important questions. Do stock prices show positive (negative) abnormal returns when included in (excluded from) an index? And if they do, what explains this price response? In this paper, the effect of index inclusion and exclusion on stock return is examined in the Dutch stock market. The effect on the price of the stock that will be included in a (higher) index is studied around the review cut-off date, the announcement date and the inclusion date. A similar approach is applied to the exclusion of a stock from an index. A large number of papers have investigated index inclusions and exclusions, mainly focusing on the S&P 500. The effect of the index reviews in the European market, and in particular the Dutch market, has been studied to a limited extent. The Dutch market is in particular interesting because it has three major stock indices: the AEX, AMX and AScX, which are respectively the large cap, mid cap and small cap stock indices of the Netherlands. This usually implies that inclusion of a company in one of these indices means that the firm is excluded from another index. A stock that gets ‘promoted’ to the AEX was thus, in most cases, already part of another index; the AMX. This makes it possible to study the index inclusion effect across the different capitalization indices. The differences in index inclusion effects between the large cap, mid cap and small cap indices of the Netherlands have never been studied before. This research also tests the Efficient Market Hypothesis. According to Fama (1970), a market in which prices always fully reflect available information is called efficient. If there is indeed a positive price response after a stock is included to an index, this strongly suggests an inconsistency with the Efficient Market Hypothesis, since no new information regarding the companies’ future prospects was released. If the Efficient Market Hypothesis of Fama (1970) does not hold, and thus asset prices do not fully reflect all available information, we can speak of an anomaly. A market anomaly is a price deviation of an asset that contradicts the Efficient Market Hypothesis in the semi-strong form. In this paper we speak of an index inclusion effect if prices respond around the review of an index, even if the price response is temporary. The aim of this paper is to examine whether index inclusion and exclusion of stocks for the Dutch indices, the AEX, AMX and AScX yield abnormal returns. In order to answer this, (cumulative) abnormal returns of stocks around the index inclusion or exclusion will be computed. The results will be linked to conceptual points and hypothesis, which are described below, to find explanations for a potential index inclusion effect. Research question: What is the effect of index inclusion and exclusion on stock return in the Netherlands? 5 The remainder of this thesis is organized as follows: The next chapter offers an overview of the empirical results of other authors and a literature review covering the conceptual points. Chapter 3 provides a description of the methodology and is followed by the 4th chapter in which the data is described. The results of this research can be found in chapter 5. Finally, chapter 6 provides the conclusion and some recommendations for further research. Chapter 2: Literature Review and Hypotheses 2.1 Previous findings on the index inclusion effect Research on the effects of index inclusion on stock prices dates back to the late 1980s. Over the past decades, empirical studies yielded several findings which are not all consistent. Nevertheless, we can find common ground in these studies, as authors mainly find that inclusion in a major market index is typically associated with both a positive price response and increased comovement between newly- added companies and the rest of the index. An overview of the major studies and key findings in this field is elaborated below. Shleifer (1986) was one of the first who studied newly included stocks into the S&P 500 index. He found that these stocks earned a significant positive abnormal return of 2.8% at the inclusion announcement. This abnormal return did not disappear in the ten days after the inclusion. A positive price effect lasted for at least a month and no evidence was found for a price reversal during the 60 days after the announcement. Jain (1987) also examined the stock price effects of S&P index inclusion and exclusion announcements. His findings strongly support a price effect in line with the S&P announcement. Stock prices showed a 3.1% excess return on the first trading day after the announcement when added to the S&P 500. Since no reversion of the excess returns was found in the 60 days after the announcement, the effect was not temporary. No significant abnormal returns were found during the 120 days before the event, which indicates that the inclusion or exclusion was not dependant on the firms prior performance.