FTSE/JSE Index Migration: Testing for the Index Effect in Stocks Entering and Exiting the Top 40

This paper seeks to uncover whether periodic changes to the constituents in the Top 40 index lead to price distortions during quarterly index rebalancing. The premise for this research follows from the notable increase in assets under management of index tracker funds both globally and locally, in recent years. A larger asset base tracking a given index would imply larger volumes of forced buying and selling by passive tracker funds when changes are made to the constituents underlying the index. This follows as the passive trackers are tracking error sensitive as opposed to being price sensitive, which should lead to predictable excesses in demand for stocks entering and supply of stocks exiting the index. The objective of this research is to uncover whether these dynamics result in price distortions in the local index, and in particular whether it can be profitably exploited by front-running anticipated changes. Our study indeed confirms the existence of a highly profitable index effect, conditional upon timing trading actions correctly and being able to accurately predict entrants and deletions ahead of the public announcement.

G11, G14

Index front-running, passive rebalancing trade