Long-Term Price Effect of S&P 500 Addition and Earnings Quality

When a company is added to the S&P 500 Index, it receives a positive price response. Several explanations for this effect have been suggested, but empirical findings do not provide a conclusive cause. The inclusion of a company in the index may strengthen managerial incentives to provide high-quality disclosures of financial data. This study is an examination of the earnings quality of S&P 500 companies before and after their addition to the index. It finds that discretionary accruals significantly decrease after companies are added to the index, which greatly improves earnings quality. This change in earnings quality provides a possible explanation for the price response to the S&P 500 addition.A positive price response has been found to follow a company’s addition to the S&P 500 Index, and the response has been found to generate significant abnormal returns of between 2.7 percent and 5.48 percent. Several explanations for this effect are possible. The increased demand for the stock from index funds and other investors adding the stock to their portfolios may explain how the prices of newly added companies are momentarily affected by index inclusion. This explanation suggests, however, that prices will reverse once the abnormal demand has subsided, but empirical studies have found that the index price effect is at least partly permanent. An explanation that allows for the long-term price effect is that the lack of a substitute limits arbitrage with S&P 500 stocks. Or the permanent price effect could be the result of new information about the expected distribution of a security’s future returns; index inclusion would provide information even though Standard & Poor’s assures investors that the investment merits of a company do not influence its selection.My study examined the quality of earnings data before and after index listing for 202 companies added to the S&P 500 in the 1990–2005 period. I find that the addition of a company to the S&P 500 does not necessarily reveal new information but does strengthen managerial incentives to provide high-quality financial disclosures. Discretionary accruals, a measure of earnings quality, are significantly larger in magnitude before index listing than after listing. The change signals a reduction in information risk. The addition of a company to the S&P 500 may increase investors’ and media awareness and, in that way, change managerial incentives to release high-quality earnings data. The change is somewhat permanent: Five years after addition to the S&P 500, discretionary accruals are about one-half their magnitude at the time of inclusion.The price response to S&P 500 addition may come from the change in earnings quality. If investors anticipate an increase in earnings quality, they will reduce the return they demand because of the lower information risk, thus causing the price to rise. Results of my study support the hypothesis that the change in discretionary accruals contributes to the observed S&P 500 effect. The results of this study support the role of information risk and accruals in pricing, which is also consistent with recent findings that companies with poor accruals quality have higher costs of capital.