S&P 500 index reconstitutions: An analysis of outstanding hypotheses

The market reaction to announcements of S&P 500 index changes shows a sustained price increase for added firms and a short-term price decline for newly removed firms. We explore the outstanding hypotheses regarding liquidity, certification, and investor awareness using new evidence. We show that the cost of equity declines following inclusion and increases following removal from the index and these changes are related to liquidity improvements and deterioration rather than changes in investor awareness. Secondly, we conclude that information asymmetry declines following addition but does not change significantly following deletion. Specifically, we show that, after controlling for other pertinent factors, stock analyst earnings forecast errors shrink when a firm is added to the S&P 500 index. These findings support the certification hypothesis to explain stock market response to index reconstitution. Finally, we explore changes in bond yields to distinguish between the type of information certified by Standard and Poors, but our results are inconclusive. Taken together, we find additional support for both the liquidity and certification hypotheses proposed in extant literature about S&P 500 index reconstitutions.