The Index Effect

Given its name, you'd think the S&P 500 index of large company stocks would include the 500 largest publicly traded corporatoins. But that would be too easy -- and the truth is more interesting anyway.

Standard & Poor's, which constructs the index, has a committee of eight staffers who meet in private every month to decide what goes in and what gets tossed. They follow guidelines pertaining to issues including liquidity, shares available to the public, sector balance and financial viability. But in the end, the index is composed of whatever the committee decides are the "leading companies in leading industries."

It's a big responsibility, seeing that Americans have $1.2 trillion invested in index funds that trac the S&P 500. In fact, the power of the index is such that the companies gaining entry often enjoy a significant, persistant gain in share price.

Hypothetically, you can make money trading on this so-called index effect, though it'll probably take a lot of effort. One strategy: buy on the date the addition is announced, and sell several days later, when the change goes into effect -- typically, you'll see a 6 percent gain, says, Vijay Singal, a Pamplin College of Business finance professor. You can do even better trading on S&P 500 deletions. When a company is knocked out of the index, the price typically falls at least 10 percent between the announcement and the effective data, then rebounds to its starting point.

Sounds like a sure thing, but Singal warns the price movements are simply historical averages -- it's impossible to predict what will happen with any particular stock. "You need a large sample of trades over a period of two years for it to work," he says.

-- Anne Kadet, Ask SmartMoney, October 2005