Ideas with Impact
UNB Faculty of Management

Do stock indexes mess with market signals? The answer is “yes,” says Dr. Joseph DeCoste, a professor of finance at UNB’s faculty of management whose recent research explores how index-based trading can distort the true performance signals of individual companies and offers thoughtful investors valuable insights and opportunities.

“When you invest in a fund that tracks an index like the S&P 500, you’re buying a little piece of every company in that index, not picking individual stocks,” says DeCoste. “That’s convenient, but it also changes the game.

Instead of investors evaluating companies one by one, they often just trade the entire index. This means that stocks can move up or down together simply because they’re in the same index, not because anything has changed in the companies themselves.”

In his research paper, “Comovement and S&P 500 Membership,” forthcoming in the Global Finance Journal, DeCoste looks at whether joining the S&P 500 makes a stock move more in sync with the overall index.

He explains why this matters: “If a company’s price starts reacting more to the index than to its own performance, it can distort the true signal of how the company is doing. That’s bad for investors trying to make smart choices, and bad for the economy if money flows into companies for the wrong reasons.”

Past research has mostly studied how stocks react immediately after inclusion. But DeCoste says he wanted to dig deeper, so he used a method called a fuzzy regression discontinuity design . “It’s just a fancy way of comparing similar companies in and out of the index to isolate the effect of joining.

This method allowed me to uncover how joining the index changes a stock’s behavior over time. What I found is that joining the S&P 500 does change how a stock moves: it starts behaving more like the rest of the index, even if nothing about the business itself has changed.”

Understanding this is important for investors. “Imagine a company joins the S&P 500,” explains DeCoste. “Over time, its stock starts moving more closely with the overall index, not because its business has changed, but because it's now part of index-based trading.

A thoughtful investor might recognize that some of these movements pull the stock price away from its underlying fundamentals. That disconnect could represent a trading opportunity, either to buy when the stock is undervalued relative to its fundamentals or to sell when it’s been pulled too far in the other direction.”

Dr. DeCoste is a member of the finance area and Director of the Centre for Financial Studies. He teaches the Student Investment Fund course, as well as Financial Data Analysis, International Financial Management, and Financial Institutions and Markets.

His recent study demonstrates that while indexes are powerful tools, they might be subtly warping the market in ways the industry is still trying to understand and, he notes, “that can create trading opportunities for a savvy investor.”

Learn more about UNB’s Faculty of Management and the Centre for Financial Studies.

Photo: New research by UNB finance professor, Dr. Joseph DeCoste, explores how stock indexes may impact market signals and how thoughtful investors might respond.