Industry Comovement after Joining an Index: Spillovers of Nonfudamental Effects

Industry Comovement after Joining an Index: Spillovers of Nonfundamental Effects ABSTRACT A substantial literature about nonfundamental, or behavioral, determinants of stock price (co)movements has developed in recent years. The inclusion of stocks into a general market index such as the S&P 500 index has been used extensively as an experimental setting to investigate this issue. Building upon existing theories, we investigate the existence of spillover effects of nonfundamental "index shocks" on non-index stocks in the same industry as a stock that is added to the general index. The results ofthis study will contribute to a better understanding of the broader economic consequences of a stock being added to a general stock index and, consequently, the nonfundamental determinants of stock price movements. BACKGROUND The Efficient Markets Hypothesis posits that asset price comovements reflect fundamental values. That is, assuming rational investors and frictionless markets, asset prices reflect the expected present value of future cash flows (using an appropriate discount rate). As a result, any correlations among asset prices result from correlations of their fundamentals. However, a substantial literature about non fundamental determinants of stock price (co)movements has developed in recent years. 1 The inclusion of stocks into a general market index such as the S&P 500 index has been used extensively as an experimental setting to investigate this issue for at least two reasons. First, the stock addition event can be considered as "information-free," meaning that it has little, in any, effect on the fundamentals of stocks added to an index.2 Second, the presence of a group oflarge institutional investors tracking the index ensures an economically meaningful demand shock effect to the index category. In fact, numerous studies have found evidence that fund flows into and out of well-defined index categories are correlated with fund returns.3 Barberis and Shlefier (2003) and Barberis, Shleifer, and Wurgler (forthcoming) provide comprehensive explanations for such nonfundamental effects. By assuming that arbitrage activities are I See, for example, Pindyck and Rotemberg (1993), Fama and French (1993, 1995), and Froot and Dabora (1999). 2 See, for instance, Harris and Gurel (1986), Shleifer (1986), Beneish and Whaley (1996), Lynch and Mendenhall (1997), Kau1,Mehrotra, and Morek (2000), and Wurgler and Zhuravskaya (2002). 3 To name a few, Warther (1995), Edwards and Zhang (1998), Fortune (1998), Goetzmann and Massa (2003), Cha and Lee (2001), Edelen and Warner (2001), Karceski (2003), Goetzmann and Massa (2003), and Ling and Naranjo (2003). I