COVID-19 SET TO RESHAPE MAJOR STOCK MARKET INDEXES

This article was first published by IR Magazine. 

Companies should be prepared for higher volatility and trading volumes over the next two weeks as a series of key indexes rebalance and adjust constituents, say market experts. The changes will be more significant than normal, they add, given the big valuation shifts brought about by COVID-19.

“Traditionally, reconstitutions and rebalances are important,” says Dan Romito, associate vice president of IR product strategy at Nasdaq. “In terms of gravity and impact, however, we’re going to see [a rebalance] that’s going to be unique for the last five years.”

On Friday, June 19 at the end of the trading day, S&P Dow Jones Indices plans to rebalance indexes including the S&P 500 for the first time in six months. Normally the process occurs quarterly but it was postponed in March due to market volatility.

At the same time, the index provider will add Teledyne Technologies, Tyler Technologies and Bio-Rad Laboratories to the S&P 500, replacing Alliance Data Systems, Harley-Davidson and Nordstrom.

The following week, stocks will see one of the busiest trading days of the year as the annual FTSE Russell rebalance completes on June 26, deciding the constituents of the key Russell 1000 and Russell 2000 benchmarks.

On June 5, FTSE Russell said there were “143 projected additions and 205 projected deletions” for its US indexes this year.

The changes will affect the numerous funds tied to these indexes, including the huge market for ETFs. S&P estimates that around $10 tn in assets tracks or is benchmarked to the S&P 500 alone, while FTSE Russell says $9 tn is connected to its US index family.

Index inclusion has become more important given that passive money “is the engine of the markets” today, says Tim Quast, president at ModernIR, an IR consultancy focused on market structure.

“Active money is about 14 percent of trading volume, so 86 percent of trading volume is something else,” he says. “And the major investment force of the day now is passive investment because that is what everybody is choosing to do.”

Given the volume of assets invested passively, Quast says inclusion has positive and negative impacts for IR teams. The positive part is that, by joining a major index, you put yourself where most of the money is.

The negative part is that it becomes harder to distinguish your story from other companies. “What we have found statistically…  is that you will develop herd behavior,” Quast says. “The objective of index money is to track shared characteristics, not unique ones.”

Understanding the impact

Some companies have seen their valuations “cut in half” and may drop out of indexes, said Mike Coffey, vice president of strategy at Q4, during an IR Magazine webinar at the start of June.

Referring to the Russell rebalance, he said it’s important to understand “the amount of stock that needs to be bought or sold on June 26 because that can have a major impact on your stock price.”

Coffey advised companies to get ahead of any anticipated sales. “If you know, going into the event, that there are 2 mn shares for sale, this is an opportunity to get out there and really try to help offset that,” he said. “Do the marketing. Talk to the names you’ve been meeting with over the last couple of years that maybe haven’t bought the stock.”

IR teams, in particular, need to understand the potential impact of any changes so they can keep the C-suite informed, Coffey added: “‘The worst that can happen is to see a 4 mn-5 mn share block go off on the bell and really not have an explanation for senior management.”

Quast agrees that companies can use targeting to anticipate the impact of index changes. “If you’re added to an index, make sure you circle around and call your growth names because it probably will benefit you in the short run,” he says. “Growth money buys appreciation – it’s like surfing a wave.”

IR teams should note, however, that rebalancings are not a good time to hold an important announcement, such as earnings. “There can be a dramatic effect on your stock, and it may have zero to do with what you said,” says Quast, who compares the situation to trying to give a speech over a leaf blower.

New-look market

Romito says the market changes brought about by COVID-19 have complicated traditional market cap and style classifications. Companies will have to watch carefully how these changes feed through to stock pickers on the buy side.

Ahead of the latest rebalancings, Nasdaq analyzed the US market and finds there is now considerable overlap between the smallest companies on the S&P 500 and the largest companies on the S&P 400 Mid Cap Index. It also finds some companies in the S&P 500 Value Index now have very high forward-looking multiples.

The changes “set a new paradigm for what constitutes a value play, a growth play, even a particular index play,” says Romito.

In light of the upcoming index changes, active managers tracking ETFs and larger benchmarks will have to consider how to recalibrate their portfolios, adds Romito.

“What we’re seeing is that concentration ratios in given portfolios are not out of whack but they’re deviating from what they were traditionally,” he says. “Volatility within the S&P [500] alone has gone, in some sectors, four to five times higher than what’s been experienced in the last 10 years.

“Is a mid-cap investor going to be comfortable with larger mid-caps or smaller mid-caps? If I decrease exposure to industrials, then by definition I’m going to increase exposure to another space. Am I comfortable with that?”

From his conversations with active managers, Romito says they appear to know tactically what they want to do. But stock pickers are likely to “take their time” adjusting portfolios, given the continuing market uncertainty.