The Shrinking TSX
Another ones bites the dust. As I noted last year, the TSX Composite Index has been shrinking for years. That seems to be continuing, though at a slower pace. When Enerflex Systems Income Fund (EFX.UN) leaves the index next week as the result of a buyout (see Standard & Poors press release) the TSX Composite will be down to 210 companies, a third fewer than a mere nine years ago. One would have thought equity markets should expand over time, not shrink.
When one considers that the largest US all-company index the Wilshire 5000 Total Market Index contains about 5000 companies, it is apparent how small and thin the Canadian market is. All the more reason to diversify outside Canada in my opinion.
The Shrinking Index Effect
The index effect is the excess returns or profits from trading on a stock that is being added to a major index, such as the TSX 60, the S&P 500 or the UK's FTSE 100. The addition of a stock to an index causes its price to rise unduly as indexers (and closet indexers) rush to buy it. A neat little 2008 paper by Aye Soe and Srikant Dash from Standard and Poors called The Shrinking Index Effect showed how the opportunity to make such profits has declined considerably to the point they think "... its days as a profitable trading strategy may be numbered". They looked at five different major indices, the above three plus Japan's Nikkei 225 and Germany's DAX 30.
The paper is a good brief primer on the various indices and how they are changed. It's interesting that the FTSE 100 and DAX 30 changes are quite mechanical and predictable while those of the TSX 60 and the S&P 500 are not.
Buyers of passive index funds, which automatically buy into index changes and have to pay the higher price that follows the announcement price pop, may take heart that they are being less taken advantage of. To quote the authors: "... hedge funds and proprietary trading desks have increased their market participation in index trades to exploit this opportunity. As with any arbitrage opportunity, increase in arbitrageur activity has diminished profits." Arbitragers are not the only factor at work but the net effect is the market becoming more efficient! The chart image below taken from the study shows the big decline - the upper vs the lower line at time ED (ED means the day the entry of a stock into the index takes effect) - in available trading profits from TSX 60 changes between 1998-2003 and 2003-2008.
Of course, the efficiency process is never finished. Srikant Dash and Berlinda Liu suggest in another paper at SSRN called Capturing the Index Effect via Options, that arbitragers can continue to make large excess profits (31% on average on the S&P 500) by trading options instead of the stock itself.