The effect of inclusions and exclusions of stocks from the JSE Top 40 and FTSE/JSE mid cap indices on liquidity.

Abstract

The inclusion and deletions of stock from the equity indices provide an important insight into a company’s performance. There is evidence there are no studies on the effects of inclusions and exclusions of liquidity in a South African market as previous studies in such a market relates to price and index rebalancing effects as a result of inclusions and exclusions to the FTSE/JSE and JSE Top 40. The insights that international studies provide are useful and these effects explored in a South African context would be useful and close the gap in this area of research and this is one of the main aims of the study. The lack of studies analysing the impact on liquidity as a result of inclusions and exclusions to the JSE Top 40 and Mid Cap Index is a disadvantage to South African investors, companies, and regulators. Therefore, the primary objective of this study is to investigate the effect of inclusions and exclusions on the Top 40 and Mid Cap Index on liquidity as well as to determine how does the size of a firm impacts the liquidity effects of an index addition or deletion. The paper seeks to determine these effects by using an event study methodology by regressing a number of different liquidity proxies (turnover, aggregate turnover, bid-ask spread, percentage spread and Amihud Illiquidity measure) using daily data for the companies that have been included and excluded from the indices. This study analyses 44 inclusions and exclusions on the JSE Top 40 and 73 and 81 inclusions and exclusions on the Mid Cap index from January 2010 to December 2020. The results from this study provide important insights into the effects of index revisions and firm size on liquidity. For stocks that form part of the inclusions to an index, there in an increase in liquidity as a result of the increased trade after the stock was included in the Top 40 and provides support from the Downward Sloping Demand Curve Hypothesis, Price Pressure Hypothesis and Liquidity Cost Hypothesis. For exclusions stocks, shows a decrease in volume traded and increasing spreads for the Top 40 and indicates that this diminished liquidity observed for such companies that find themselves excluded in both the Top 40 and Mid Cap indices which supports the information cost liquidity hypothesis.