Understanding the impacts of index recompositions

Abstract

The index effect suggests there is an excess return associated with index recompositions. Several hypotheses have been developed to explain this phenomenon, but the existing literature in the Nordic context remain limited and inconclusive. While previous studies have highlighted significant abnormal performance during index recompositions, the regulatory frameworks and investment strategies are constantly changing. By investigating the short-term effects of changes in index constituents, and how it affects the analyst coverage and earnings forecasts, our study aims to provide new insights on the market dynamics in the Nordic markets. Further, we seek to contribute to a broader understanding of market efficiency and the implications associated with stock index adjustments.

This study uses event study methodology and cross-sectional regressions to examine the index recompositions on the four largest Nordic indices through the period 2002-2023. We find that inclusion (exclusion) to the index leads to positive (negative) cumulative abnormal returns and that the market response is immediate. Further, we show that inclusion (exclusion) leads to an increase (decrease) in analyst coverage, and affects analysts EPS forecasts; inclusion is associated with more optimistic EPS forecast and lower dispersion. Our results indicate that index adjustments does not highlight market inefficiencies, as they convey new information to the market regarding the future prospects of the firms.