Stocks surge after news that they will be listed in a new index.  When news breaks that Joe Schmo’s company will now be used in the S&P 500 index, chances are the price is radically affected.

Indices give good feelings.  The idea that a company is good enough to be used as an example gives investors that warm fuzzy feeling inside that the business is thriving.  Being listed in a index gives the idea of stability and confidence that the corporation will succeed.  Investors like to see other investors doing the same thing, when an index picks up a stock you can bet that investors are taking notice and getting in.

The index fund effect is another reason that stock prices boom.  There is billions, if not trillion of dollars in funds meant to mimic the biggest and the smallest of index funds.  These mutual funds carry the same positions and weight as modern indices and charge a modest fee for account management.  These are largely set and forget kind of programs for the manager, who merely copies the holdings of the chosen index.

When a company gets added to an index, the index funds have to automatically adjust to the new corporation.  The fund will shift capital out of the dropped company and place it immediately into the new addition.  This creates a surge in the price of a stock from near overnight demand.  For indices like the S&P500 this is huge news because the amount of funds trying to replicate the results of the index is in the hundreds.  Almost and family of funds will offer an S&P tracking fund meant to trade parallel to the value of the S&P500 itself.

Being a part of an index can hurt a stock as well.  In periods of negative returns, equity is taken out of the market, hurting the indices as a whole.  When things turn sour at XYZ which is listed on the Dow, withdraws likely resulting from negative performance will probably affect the value of ZYX which happens to be an entirely unrelated company.

Getting in an index is paramount to a stock price’s success.  When capital flows into the markets it is often parked in index funds particularly S&P500 funds.  The added demand from institutions means higher stock prices and lower float, ultimately leading to less volatility in the market.