INVESTMENT COMMUNITY PERSPECTIVE

All IROs probably know whether their stock is included in an index, and if so, which indexes and sub-indexes. (Hint: if you do not, find out immediately.) But how do stocks get selected for index inclusion? Why does inclusion or exclusion matter? What happens if a stock is being included or excluded in an index? (Is it an event like a big party, or a wake?)

The Selection Process

Sorry, index inclusion is not something for which you can ask; rather, it is mathematical, as in formula driven. The situation is the same with respect to removal. Effectively, the decision is out of your control, but a small part of it may be within your influence.

Selection (or removal) occurs quarterly, and a stock must meet certain qualifications and then meet liquidity and capitalization hurdles. For eligibility on the S&P/TSX Index, the securities must be listed on the TSX for at least six months, domiciled in Canada and the security itself must meet certain criteria (basically, be a common stock no preferred stocks, exchangeable shares, warrants, installment receipts, stapled securities, or securities issued by a mutual fund corporation qualify.)

Liquidity is important to ensure reliable price discovery through trade. Liquidity is measured by looking at the total trade in a year (all Canadian venues) divided by the total share float; at least 25% must be achieved for eligibility.

As for capitalization, a $1 minimum volume weighted average price (VWAP) over the past three months is required as well as representing a minimum weight of 0.025% (VWAP) of the index based on the last three trading days of the month-end prior to the quarterly review.

An IRO’s potential area of influence comes into play under the liquidity requirements, through helping to build an active market for your Company’s security.

Why the Fuss?

Some funds can only buy stocks that are included in the index, thus limiting their investable universe. In addition, exchange-traded funds (ETFs – which are considered unmanaged), which are now very common, are also only permitted to hold stocks that are included in the index. Plenty of funds are not restricted; however, it is easier to be in a universe where certain investors are virtually required to own your stock. And the performances of many portfolio managers are benchmarked against indexes and sub-indexes. If your stock is in an index, you better know the sub-indexes as well, and your company’s relative performance against its peers.

More Than One Index Out There

We only touched on the requirements to be included in the S&P/TSX index, but there are others out there also, and it certainly would be worth your while to know some of them, their requirements and members. For instance, as many funds are now global, global indexes are important too. The MSCI (Morgan Stanley Capital International) is an often-used global index, and obtaining information on this index requires a subscription.

The Games People Play

Forget about your own job for a minute and imagine yourself as an international trader. Knowing which companies could be included in an index (or removed), and when, could be important trade information. Recognizing that funds will have to own the stocks coming into the index should mean an uptick in stock buying (and that removal should mean stock selling), you could trade ahead of the market. And this is exactly what some traders do; based on when the index rebalancing occurs, they run the math to figure out the potential index additions and deletions, and even the potential volumes needed, and they trade accordingly. They make calculated bets on the moves, and trade ahead of the pack. Thus, a stock that is a potential index inclusion can see trade pick up ahead of the announcement – and here the IRO thought the reason was great marketing skills! These traders then sell (or buy) the stock to (from) the indexers. Yet another layer of the market onion revealed.

More Fun and Games

Once included in an index, the permutations and combinations of potential trade that can occur are quite staggering and can appear to defy simple logic, but there may be a very rational reason for the trade. For example, someone may have determined that when oil and gas prices are at a certain level, the oil and gas stocks should trade within a certain value range. Let’s say that the stocks are trading above those ‘pre-determined’ levels; well, someone might just do an arbitrage trade that effectively shorts a basket of oil and gas stocks and goes long a basket of the ‘commodity’ in a form of hedged trade. An IRO may be doing some head scratching regarding trading activity that day, thinking that it doesn’t make sense, but missing the bigger picture.

Manage What You Can Influence

As mentioned, an IRO cannot control the market, but may be able to influence it by providing a broad spectrum of investors with accurate and timely information to can make informed decisions. By making a better market for a company’s stock, the IRO assists in improving its liquidity. And should the company meet capitalization requirements, perhaps it will one day be included in one or more indexes.