What’s it worth for a company to be included in an important equity index, such as the S&P 500? A great deal, it would appear, judging by how frequently executives admit that the planning and timing of acquisitions, divestitures, and other strategic moves are influenced by hopes of getting companies into equity indexes and keeping them there.

Our research into the effect of inclusion in the S&P 500 on a company’s share price indicates that entry into or expulsion from a major index does indeed have an impact. Yet it is short-lived, for membership isn’t a factor in long-term capital market valuations.¹ Executives should therefore plan and pursue strategies irrespective of whether these measures might exclude companies from or help companies gain entry to the major indexes.

On the surface, becoming a member of an index such as the S&P 500 is appealing because many large institutional investors track these stocks by purchasing them. Once a stock is added to the index, it is argued, demand—along with the share price—will increase dramatically as institutional investors rebalance their portfolios. As long as that demand continues, so will the premium.

Adjustments in 2000 to the companies listed on the S&P 500 did nothing to dispel this myth. When Nortel Networks, Royal Dutch/Shell, Unilever, and four other companies from outside the United States were removed and replaced by the same number of US corporations, the departing ones lost, on average, nearly 7.5 percent of their value in the three days after the announcement. The stock price of the new entrants—which included eBay, Goldman Sachs, and United Parcel Service—increased by more than 3 percent during the same period.

To determine whether the S&P 500 index gave stocks a longer-term strategic price advantage, we analyzed the effect of inclusion on 103² US companies listed since December 1999.³ Academic research, seeking to determine how investors might devise profitable trading strategies to take advantage of a company’s inclusion, has focused largely on short-term price patterns at the time of index changes. We, however, focused on longer-term price fluctuations to see whether membership in the index creates a lasting price premium.

To that end, we analyzed abnormal stock returns over an 80-day test period, from 20 days before the effective date of inclusion to 60 days afterward.⁴ Clearly, the best measure of abnormal returns⁵ is whether the new entrants enjoy permanent positive returns as a result of inclusion. And they clearly did not. Indeed, though abnormal returns increased in the 10 days prior to the effective date—to a maximum of about 7 percent and an average of about 5 percent—they went back to zero within 45 days. The pattern of statistically significant positive returns disappears after a mere 20 days (Exhibit 1).

This result is consistent with the phenomenon of liquidity pressure, which drives up share prices initially as investors adjust their portfolios. Prices subsequently revert to normal when portfolios are rebalanced. In the end, new entrants to the S&P 500 did not enjoy a permanent price premium. Capital markets proved to be quite efficient, underlining the fact that the value of stocks is ultimately determined by their cash flow potential and not by membership in major equity indexes. As the S&P 500 is probably the world’s most widely and intensively tracked index, we speculate that this finding also holds for others, such as the FTSE 100 and the Dow Jones Industrial Average.

We also looked at companies ejected from the S&P 500 over the same period and found similar patterns of temporary price change (Exhibit 2). The price pressure following exclusion from the index faded after two to three weeks.

Since no lasting effect on share prices can be gained from membership in a major index, companies shouldn’t refrain from spin-offs and divestitures that would exclude them. Nor should they pursue major transactions solely to gain entry. Our findings and recommendations, however, may not apply to the stocks of every company. The inclusion in international equity indexes of companies based in emerging markets might represent a recognition of those companies’ quality, which could spark coverage by analysts and interest among investors in US and European markets. The result could well be a permanent increase in the stock price of companies that gain access to these indexes.