Consequently, the benchmark reconstitutions create an important upward bis in the earnings growth of the S&P 500 index. The analysts calculated that the difference in the year-over-year earnings growth rate of the S&P 500 using all the stock sin the index, compared to the growth rat eof the index excluding new entrants, revealed a median annual gap of 1.2%. Additionally, the regularly reconstituted index outperformed an index excluding new entrants for eight consecutive years.
“The new companies that are added to the index typically have much higher margins than both the companies removed and the surviving constituents …with faster prior revenue and earnings growth, and higher margins, the stocks added to the index typically have performed much better over the few years before their inclusion,” Morgan Stanley said.
While index-based ETFs may passively reflect a benchmark, there is some active component in the underlying indices that could bolster growth. In the case of the S&P 500, the index trims companies with poor earnings per share growth but adds more quickly expanding businesses.
For more information on index-based funds, visit our indexing category.
Max Chen contributed to this article.
Full disclosure: Tom Lydon’s clients own shares of SPY