Gaming the FTSE 100 Index

TL;DR: In this paper, the authors investigate two types of gaming, namely strategic gaming and tactical gaming, and conclude that about 5% of entries to the FTSE 100 appear to be the result of gaming.

Abstract: In the UK (unlike the US and many other countries), companies enter and exit the main stock market index (FTSE 100) according to a clear set of rules based on market capitalisation. This creates an opportunity to game the system to secure or retain FTSE membership by manipulating capitalisation. There is considerable evidence in extant studies that index membership is beneficial, both for shareholders and managers. Hence, companies may adopt financial strategies designed to acquire or retain membership. We investigate two types of gaming. We define strategic gaming as a situation in which companies, which may initially be a number of places away from the boundary, make abnormal share issues cumulatively over several quarters. We find strong supportive evidence for this. For tactical gaming, which would involve companies in the very closest proximity to the boundary, we do not. Our analysis shows that gaming is limited to companies outside the index trying to get in. Companies that are close to exit do not game to retain their index place. The high natural volatility of market capitalisation makes success of gaming uncertain. Our central estimate is that about 5% of entries to the index appear to be the result of gaming.

Summary

1. Introduction

• This paper investigates whether quoted companies in the UK manage their market capitalisations to gain entry, or avoid relegation, from the main stock market index, the FTSE 100.
• Under these circumstances, companies, acting in the interest of their shareholders, should be expected to actively seek membership.
• The authors shall also review the empirical evidence for share price and other changes associated with index membership changes.
• The authors then set out their hypotheses, which relate both to strategic gaming (initiated when a company may be a number of places from the margin) and tactical gaming (undertaken when the company is in very close proximity to the boundary for index inclusion).

2. The significance of indices

• The practical significance of indices has been greatly enhanced by academic theories.
• Passive funds now account for about 20% of global fund management assets, and while assets under management in active funds grew by 54% to $24trn between 2007 and 2016, funds in passive mutual funds grew by 230% to $6trn over the same period, amid concerns about bad performance and high fees of active funds (Mooney, 2016).
• Basak and Pavlova (2013) show that even benchmarking against an index, a very widespread practice, can be expected to tilt a portfolio in the direction of shares included in that index.
• These facts show that entry to the main index used for index-tracking will generate substantial new demand for the shares affected (and exit will cause a substantial source of demand to disappear).

3. Demand curves for equities

• In a market with perfect symmetrical information, the authors would expect highly elastic, nearly flat, demand curves for individual shares.
• The diversity of investor portfolios and the volume of investor trading suggest a very different market environment.
• Scholes (1972), Miller (1977) and Levin and Wright (2006) all make the argument for downward-sloping demand curves in the context of heterogeneous beliefs.
• Petajisto (2011) finds that elasticity increases with firm size and decreases with idiosyncratic risk.
• With downward-sloping demand, it can be expected that index entry, by reducing the quantity available in the open market, will raise share prices and index exit will lower them.

4. Index Effects and Motives for Firms Seeking Index Membership

• Prior literature examines the impact of index entry and exit on company share prices, and various theories have been put forward to explain the stock market reaction to companies gaining or losing membership of main stock market indices.
• Below the authors review some of the main theories and evidence on index effects, which may motivate a desire for companies to gain index membership.

4.1 Imperfect Substitution

• One of the most widely cited early studies of the price reaction when a stock joins the S&P 500 is by Shleifer (1986).
• Along with many S&P studies, he only looks at additions; the effects of removal cannot generally be studied because the companies disappear.
• There is additional evidence for downward-sloping demand from index changes whose effect is not contaminated by possible information changes.
• If index membership leads to permanently higher demand for a company’s shares, and thereby higher share prices and lower cost of equity capital, index membership will be desirable.

4.2 Price Pressure

• Harris and Gurel (1986) argue that the sudden extra demand generated by tracking funds is satisfied by high cost suppliers of extra liquidity.
• These liquidity suppliers sell on the effective date and restore their own investment positions by buying as the price comes back to its equilibrium level.
• The findings of Harris and Gurel (1986) and Mase (2007) of only a short-term price pressure effect from index inclusion suggest that companies should take a neutral view of entry or exit from an index.

4.3 Information and Liquidity Effects

• There may be information content in the announcement that a specific share is to join the index.
• For the FTSE 100 it is practical to look at both additions and deletions, and it is appropriate to look at movements before the announcement date because both entry and exit can be foreseen.
• Gregoriou and Ioannidis (2006) find excess returns of 11% over the 5 day period centred on the announcement day, but these are partly reversed over the following months.
• Mazouz et al. (2014), using FTSE 100 data, also show that index entry enhances all aspects of liquidity and that liquidity is priced.
• There is, however, mixed evidence as to whether or not being relegated from the index has a permanent negative impact on liquidity and share prices.

4.4 Price Volatility

• Dunn et al. (2008) find that, although additions to the FTSE 100 index exhibit positive cumulative abnormal returns (about 3%) prior to the effective date, this is followed by a long period of negative abnormal returns.
• Deletions show a mirror image of this effect, although the movement before day 0 is stronger (-5%) and the subsequent recovery weaker.
• Stocks in a widely tracked index have a significant proportion of their market capitalisation locked away, and the traded capitalisation is smaller.
• Contrary to other studies finding index inclusion to have a positive impact on liquidity, Dunn et al. (2008) find that for additions, the shares become more volatile and less liquid, and the long-term effect on prices to be negative.
• Cooper and Woglom (2003) confirm that volatility increases when a share is added to the S&P 500 index.

4.5 Awareness and Coverage

• Chen et al. (2004) find that the total number of shareholders rises substantially (and the number of institutional owners rises too) when a company is added, but does not fall so significantly when it leaves.
• Chan et al. (2013) confirm that there are long-term effects from index membership, and also attribute them mainly to improved liquidity associated with greater analyst coverage.
• Awareness and liquidity are closely related in the literature.
• This evidence suggests that companies obtain benefits from index membership.

4.6 Earnings Quality

• Platikanova (2008) looks at earnings quality for companies that join the S&P Index.
• Focusing on accruals, she shows that when companies join the index, discretionary accruals fall (i.e., there is a more conservative accounting policy), earnings become higher quality, and this reduces information risk and increases the share price.
• Platikanova (2008) argues that this is a permanent effect and that shares added to the index outperform for at least three years after the event.
• Again, this evidence suggests that index membership is beneficial to shareholders.

4.7 Managerial Issues

• It is also possible that executives and directors might have personal reasons for seeking entry.
• There is considerable status associated with senior positions in FTSE 100 companies.
• The benefits may, however, go beyond mere status.
• Main and Hine (2012) also study the determinants of executive pay in the UK and find index inclusion to have a significant impact on executive pay, even when controlling for firm size, share performance and director characteristics, using firm fixed effects and year dummies.
• This suggests managers would have personal incentives to ensure their firm gains or maintains membership of the FTSE 100 index, irrespective of whether index membership is beneficial to shareholders or not.

4.8 Press Comment

• In 2011 and 2012 there was concern in the UK about foreign companies (mainly from the former Soviet Union) which had obtained entry to the FTSE 100 despite a low free float and corporate governance structures which were not subject to UK control.
• The FTSE organisation proposed to change the rules to exclude them.
• The reaction from the businesses affected was swift and hostile.
• The Financial Times carried articles such as “(Polymetal’s) founder talks about why he has set his sights on the FTSE 100” (Kavanagh, 2011) and “Resolution has hit out at a planned clampdown on unconventional corporate structures which threatens the life assurance group’s position in the FTSE 100 index” (Gray, 2012, p. 23).
• It is clear from articles such as these that managers often have a strong desire for their firm to be included in the FTSE 100 index.

4.9 Literature Conclusion

• As is so often the case, this substantial body of literature contains varied and sometimes contradictory arguments and findings as to whether companies benefit from being a constituent firm in a major stock market index such as the FTSE 100.
• Overall, however, the authors would endorse the view of Chan et al. (2013, p. 4921), who conclude their review of current literature with the statement that “Clearly there are several fundamental reasons to expect a permanent, long-term price effect from the addition of a stock to the index.
• …the driving factors for added stocks should work in the opposite direction for deleted stocks”.
• This would suggest that companies, maybe particularly those around the boundary for index inclusion, would have incentives to try to manage their market capitalisation so as to gain or maintain index membership, or to avoid being dropped from the index.

Figures

Table 8: SIF Increases in Excess of 10% by Boundary Firms

Table 4: SIF Increases in Excess of 10% for Largest 200 Firms

Table 5: Financial Characteristics of the Boundary Firms

Table 7: Predicted and Actual probability of large SIF

Table 1: Descriptive Statistics for Market Value and SIFs

Table 9: Absolute Changes in Rank, SIF and Firm Specific Variability

Table 6 Panel A: Probit analysis of companies making large issues

Table 2: Position of companies prior to entries and exits from the FTSE100 Index

Table 6 Panel A: Probit analysis of companies making large issues

Table 3: Capitalisation Changes Required to Gain FTSE 100 Membership

Full text

Edinburgh Research Explorer
Gaming the FTSE 100 Index
Citation for published version:
Danbolt, J, Hirst, IRC & Jones, E 2018, 'Gaming the FTSE 100 Index', British Accounting Review, vol. 50,
pp. 364-378. https://doi.org/10.1016/j.bar.2017.09.005
Digital Object Identifier (DOI):
10.1016/j.bar.2017.09.005
Link:
Link to publication record in Edinburgh Research Explorer
Document Version:
Peer reviewed version
Published In:
British Accounting Review
General rights
Copyright for the publications made accessible via the Edinburgh Research Explorer is retained by the author(s)
and / or other copyright owners and it is a condition of accessing these publications that users recognise and
abide by the legal requirements associated with these rights.
Take down policy
The University of Edinburgh has made every reasonable effort to ensure that Edinburgh Research Explorer
content complies with UK legislation. If you believe that the public display of this file breaches copyright please
contact openaccess@ed.ac.uk providing details, and we will remove access to the work immediately and
investigate your claim.
Download date: 10. Aug. 2022

1
British Accounting Review
Gaming the FTSE 100 Index
Jo Danbolt
1,*
, Ian Hirst
2
, and Edward Jones
3
1
University of Edinburgh Business School, 29 Buccleuch Place, Edinburgh, EH8 9JS, UK, Email:
Jo.Danbolt@ed.ac.uk
2
School of Management and Languages (Emeritus), Heriot-Watt University, Riccarton, Edinburgh, EH14 4AS,
UK, Email: I.Hirst@hw.ac.uk
3
School of Management and Languages, Heriot-Watt University, Riccarton, Edinburgh, EH14 4AS, UK,
Email: E.Jones@hw.ac.uk
*
Corresponding author.
Keywords:
Index Game; Index Effect; FTSE 100; Stock Market Index; Additions and Deletions

2
Gaming the FTSE 100 Index
Abstract
In the UK (unlike the US and many other countries), companies enter and exit the main stock
market index (FTSE 100) according to a clear set of rules based on market capitalisation.
This creates an opportunity to game the system to secure or retain FTSE membership by
manipulating capitalisation. There is considerable evidence in extant studies that index
membership is beneficial, both for shareholders and managers. Hence, companies may adopt
financial strategies designed to acquire or retain membership. We investigate two types of
gaming. We define strategic gaming as a situation in which companies, which may initially
be a number of places away from the boundary, make abnormal share issues cumulatively
over several quarters. We find strong supportive evidence for this. For tactical gaming, which
would involve companies in the very closest proximity to the boundary, we do not. Our
analysis shows that gaming is limited to companies outside the index trying to get in.
Companies that are close to exit do not game to retain their index place. The high natural
volatility of market capitalisation makes success of gaming uncertain. Our central estimate is
that about 5% of entries to the index appear to be the result of gaming.

3
Gaming the FTSE 100 Index
1. Introduction
This paper investigates whether quoted companies in the UK manage their market
capitalisations to gain entry, or avoid relegation, from the main stock market index, the FTSE
100. There is a very substantial empirical literature suggesting that membership of major
stock market indices increases a company’s share price and therefore lowers its cost of
capital. Under these circumstances, membership becomes a valuable asset for companies. We
would expect, other factors equal, that they would, where possible, actively seek to acquire
this asset.
It is well established that companies manipulate their earnings and accruals
(Burgstahler and Dichev, 1997), manage their own reward systems (Burns and Kedia, 2006;
Heron and Lie, 2007), manage forex prices and interest rates (banks) (Gandhi et al., 2016;
Ryder, 2014), and manipulate contract bids (Connor, 2011). Why should they not manage the
FTSE system too? If there are specific rules which identify companies to be added and
removed from the index, management can attempt to game the system by pushing their
company to the front of the queue. Using data relating to the FTSE 100 index in the UK, this
paper explores the evidence for such managerial index gaming. To our knowledge, this
particular game has not been identified in the literature before.
The paper is structured as follows. We start by looking at the significance of indexing
in current equity markets. Then we shall briefly review the arguments and evidence for
downward-sloping equity demand curves. If demand is downward-sloping, the extra demand
from index-tracking funds would generate higher share prices and lower costs of equity
capital for FTSE 100 member companies. Under these circumstances, companies, acting in
the interest of their shareholders, should be expected to actively seek membership. We shall

4
also review the empirical evidence for share price and other changes associated with index
membership changes. We shall explain the rules governing entry and exit from the FTSE 100,
noting that the rules in the UK are very different from those in the US. Our hypothesis that
companies manage entry would not make sense in the US system. We then set out our
hypotheses, which relate both to strategic gaming (initiated when a company may be a
number of places from the margin) and tactical gaming (undertaken when the company is in
very close proximity to the boundary for index inclusion). We test them using data from 2005
to 2012. Finally, we consider possible explanations for the management behaviour we
uncover.
2. The significance of indices
The practical significance of indices has been greatly enhanced by academic theories.
The Efficient Markets Hypothesis and Capital Asset Pricing Model have encouraged a
passive style of investing based on a portfolio that includes the full set of risky assets
available in the market, weighted by their market capitalisations.
The practical consequence of these developments has been that index-tracking funds
now hold a significant portion of the global equity pool. In the US, the percentage rose from
11.4% in 2003 to about 18.4% in 2013 (Doshi et al., 2015), while in the UK, 20% of the
market was in fully passive strategies in 2014 (Investment Association Asset Management
Survey, 2015). Passive funds now account for about 20% of global fund management assets,
and while assets under management in active funds grew by 54% to $24trn between 2007 and
2016, funds in passive mutual funds grew by 230% to $6trn over the same period, amid
concerns about bad performance and high fees of active funds (Mooney, 2016).

Frequently asked questions

Q1. What are the contributions in this paper?

The authors investigate two types of gaming.