Index-tracking funds are not allowed to jump the gun when it comes to guessing which stocks will get promoted or relegated but traders are under no such obligation
The popularity of index-tracking funds ensures that stocks about to make the move into the big time, defined in this instance as inclusion in the FTSE 350 (i.e. the FTSE 100 + FTSE 250), tend to enjoy a bit of a boost ahead of their elevation to the index.
An index tracking fund is a fund that seeks to emulate the performance of a specific stock market index by ensuring its portfolio weightings mirror those of the index it is tracking; thus, for instance, if the market capitalisation of (LON:BP) is equal to 7.0% of the market capitalisation of the FTSE 100 as a whole, then fund that is tracking the FTSE 100 would adjust its shareholdings to ensure BP is 7.0% of its portfolio.
Index trackers are not interested in buying shares that are not in their benchmark index; their selling point is that they are cheaper than “discretionary” (i.e. stock-picking) funds because they don’t have to spend all that time, effort and money researching companies.No one seems to blame these funds for tracking the “wrong” index but they do occasionally risk the ire of investors if they are not bang-on in emulating the performance of their chosen index.
Getting ahead of the curve
So why do stocks tend to get a bit of a boost before they gain promotion to an index, given that the index trackers have to wait until promotion to the index is confirmed?
Well, that’s because traders can see that a stock is about to make it into the index and they know that this will trigger a round of buying and selling by the index trackers as they adjust their weightings.
Falling out of the FTSE 100 into the FTSE 250 is not the end of the world, as there are funds that track the FTSE 250 so although relegation to the mid-cap index would spark selling by the FTSE 100 trackers, this would be offset to an extent by FTSE 250 trackers buying the stock.
Using Royal Mail as an example, Richard Hunter, the head of markets at interactive investor, explained to Proactive: “If a company runs both a FTSE100 tracker and a FTSE250 tracker, they would not need to buy any more Royal Mail shares, but simply reclassify them.”
Research on the size of the lift a stock can expect from elevation to the FTSE 250 is hard to find and may not even exist; after all, what would a trader do with that knowledge? All said trader needs to know is: stock gets promoted, stock goes up.
Certain funds are not index trackers per se but they will benchmark their performance against a particular index, as a result of which they end up effectively shadowing it. These indices are free to take a punt on stocks that look set to get promoted ahead of the promotions and relegations being officially decided, as are retail investors.
“There is also likely to be extra buying at the margins from investors large and small who are wishing to join the momentum trade – needless to say, if a company is about to be promoted, their share price has recently been on a tear,” Hunter said.
Being in the FTSE 100 has a certain cachet
According to Susannah Streeter, the senior investment and markets analyst at Hargreaves Lansdown, Moonpig, Trust Pilot, Dark Trace and are all likely to join FTSE 250, while () is set to make a rapid return to the FTSE 100 in this quarter’s reshuffle.
Speaking to Proactive, Streeter said relegation from the FTSE 350 possibly has more of an impact on a share price’s performance than does promotion to the index.
This makes sense as while there might be money made punting on stocks that look like they will make the step up to the big league, punting on a stock moving the other way – i.e. getting relegated – requires selling the stock short, which is a bit more of a faff (it involves borrowing shares from an institutional investor, selling them and then buying them back later, hopefully at a cheaper price).
As such, it is looking like bad news for Sabre Insurance Group, Group, and Wickes, all of which Streeter expects to get the chop from the FTSE 250.
Meanwhile, engineering firm () is set to head back to the FTSE 250 after a brief sojourn in the FTSE 100.
“There is a prestige element to being in the FTSE 100,” Streeter said.
“Not that that did much good for Renishaw, which is currently up for sale,” she added.
Read More: Royal Mail PLC and ITV PLC on the up; why promotion to the FTSE 100 matters