When companies are added to the FTSE EPRA/NAREIT index, their share prices and trading volumes increase permanently. Chris Brooks, Konstantina Kappou, Simon Stevenson and Charles Ward investigate the ‘index effect'
The expansion of the REIT industry from the 1990s was facilitated by changes in legislation and regulation, and REITs now are widely recognised as a vibrant and important sector of the stock market. Studies have shown that liquidity and the profile of REIT stocks have increased enormously over the past 20 years, but that change has raised new questions about the behaviour of REIT stock prices.
One such question concerns the ‘index effect', a phenomenon where the addition to, or deletion from, a stock index causes a change in the price, trading volume, volatility or operating performance of the stock concerned. A stock entering an index will automatically receive increased demand from institutional investors - principally index tracker funds and exchange trade funds (ETFs) - while a deleted stock will experience reduced demand. Noting this repeated pattern of behaviour, arbitrageurs have found ways to earn profits by buying the stocks of added firms, or selling those of deleted companies, before index funds make their trades and then selling them (or buying them back) when index funds have completed their transactions. The index effect has been widely investigated in the stock market as a whole, but there has been very little comprehensive research focused specifically on real estate and nothing on the European market.
A study that we have conducted on behalf of the European Public Real Estate Association (EPRA) shows that when listed real estate companies are added to a FTSE EPRA/NAREIT sector index, their share prices and trading volumes increase permanently, confirming the importance of these indices in raising investor awareness of well-performing companies and aiding liquidity.
Our study focuses on the EPRA indices, published in collaboration with FTSE and NAREIT, which are the leading benchmarks for the listed real estate companies globally, encompassing a total market capitalisation of approximately $1trn (€800bn). These indices are used to track general patterns in real estate markets worldwide. Companies that meet certain capitalisation, liquidity and reporting requirements are eligible for inclusion in an index that matches their geographical or sector profile.
Our investigation is based on a sample of nearly 400 index changes since 1999, and investigates both the short-term impact of index recomposition and the longer-term effects for both additions and deletions. As far as deletions are concerned, we restrict our study to those companies that are deleted from the index but that continue to exist outside the index - so that we exclude companies that were removed due to bankruptcy or merger, for example.
Changes to the composition of the indices are made and announced by EPRA on fixed dates every quarter, and as such we would not expect a big jump in prices - either upwards for additions or downwards for deletions - as the announcements should in the main reflect market expectations. Therefore, there should be gradual movements in prices before the event, unless index replicators ignore prior information and wait until the event date in order to minimise their tracking errors. The results bear this out, as we see an average pre-event weekly return of 2.4% for inclusions and a fall of over 10% for deletions. Interestingly, there is an almost zero return on the event day itself, indicating that index changes are widely anticipated and acted upon before they actually occur.
The study shows that the average long-term impact of a company being added to an EPRA index is a 13% increase in its share price (8% over the FTSE EPRA/NAREIT Developed Market Index benchmark) and permanently higher trading volumes. Conversely, companies that are deleted from an index see their share prices fall when they leave the index, although the price drops, at 3% (4% below the benchmark), are less pronounced than the rise when companies are added. The study also finds that inclusion in, or deletion from, an index has no significant affect on the volatility of a company's share price or on its operating performance, as measured by earnings per share.
Why do we see such a strong impact when firms are added to the EPRA indices? There are several possible explanations. First, index membership increases liquidity through the enhanced trading activity that arises as a result of heightened investor awareness of specific firms that enter the media spotlight following the announcement of either an addition or a deletion, and we find that trading volumes indeed rise for both. Market participants are aware that a company will enter the index and exert buying pressure on the days before entry, and these purchasers could be index funds or speculators anticipating a further share price rise when the inclusion actually happens.
A second reason why we might see an EPRA index effect is because an announcement that a firm will enter the index is viewed as a strong positive signal of its strength and likely future performance, and vice versa for deletions. In the context of membership of the Standard and Poor's 500 index, this phenomenon has been termed the ‘gold seal' of index membership.
Despite the protestations of index providers that their decisions contain no new information that is not already available to market participants, investors seem to prefer index member stocks. Our research has shown that this is just as true in European real estate as it is in the stock market as a whole, and confirms that the REIT sector reflects the characteristics of the stock market as a whole and should not be seen solely as a specialist interest category.
Professor Chris Brooks, Dr Konstantina Kappou and Professor Charles Ward work for the ICMA Centre, Henley Business School, University of Reading. Simon Stevenson, is professor at School of Real Estate and Planning at Henley Business School