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March 26, 2006 7:09 pm

Google may find the S&P effect to be temporary

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Google’s addition to the S&P 500 index last week suggests that there are few more reliable ways for a company to boost its stock price than by joining the blue-chip index. However, for most companies, it seems that the share price reaction is nowhere near as sharp as it used to be.

Shares in Google jumped almost 7 per cent on Friday after S&P said the internet search giant would replace Burlington Resources in the index.

Efforts by Wall Street to second-guess which company will join the S&P next have intensified over the years as have strategies designed to take advantage the so-called “index effect” when a new stock joins. About $1.2 trillion (€1 trillion) is now invested in index and exchange-traded funds (ETFs) tied to the S&P 500, compared with $460bn 10 years ago, and many other investors have holdings that at least partly track the index.

New instruments have fed the boom. Assets of ETFs – index funds traded like stocks on an exchange – total around $325bn, up from $100bn in 2002, and they are expected to grow further thanks to their popularity with hedge fund managers.

Conventional wisdom is that index funds would suddenly be forced to buy Google shares en masse, especially since the size of the company’s free-floating shares would give it a weighting of around 0.55 per cent in the S&P 500. “You are definitely seeing a magnifying effect,” said Christopher Johnson, director of quantitative analysis at Schaeffer’s investment research.

Merrill Lynch analyst John Davi estimates that about 30m shares will be bought by index funds – equivalent to approximately three days’ worth of normal trading volume.

However, Srikant Dash, index strategist at S&P, suggested that Google’s early gains might fade, as index funds have started using new ways to minimise their costs when changes are made to an index’s membership. “Excess returns associated with index addition announcements have diminished sharply,” he said.

Between mid-1998 and mid-2000, news of a company being added to the S&P 500 index resulted in median excess returns of 8.9 per cent from the date of the announcement to the date it became effective, according to S&P. But with many index funds increasingly trading around the effective date to minimise the cost of the change, the price increase fell to only 2.9 per cent last year.

Marc Pado, US market strategist at Cantor Fitzgerald, suggested that Google’s 7 per cent rise could be due to speculative buying by hedge fund managers planning to sell to index funds on Friday, when Google’s S&P 500 membership becomes effective.

As Mr Dash sees it, the index effect has become a cat-and-mouse game between hedge funds looking for a quick profit and index funds looking to avoid overpaying for a stock they are forced to buy.

Indeed, Mr Pado said Google shares could fall next Friday as hedge funds find themselves with too many shares and not enough buyers. “Ultimately, Google’s fundamentals haven’t changed,” he said.

Companies joining widely tracked benchmarks often see shares rise as fund managers who track the index rush to add the stock to their portfolio. But the so-called “index effect” has increased over time as indices have grown in importance.

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