When a stock rises (either temporarily or permanently) before its inclusion into an index, that means index funds need to be purchasing the stock at inflated prices.
Doesn't that mean when you purchase index funds, you are significantly overpaying for some stocks?
Shouldn't you purchase some stocks that's just outside the SP500 so that when they're added you can make a gain?
Doesn't that mean when you purchase index funds, you are significantly overpaying for some stocks?
I think "significantly" is a bit of an overstatement (it's not like stocks double when their inclusion is announced), and the vast majority of index fund buyers are not trying to "time the market" but are investing long term, so the future growth would far outweigh the slightly larger cost basis. In addition, since these indexes are market cap weighted, new entries make up a very small portion (e.g. much less than 1/500 of the S&P 500) of the index, so the initial bump in price has a very minor on the value of the index.
Shouldn't you purchase some stocks that's just outside the SP500 so that when they're added you can make a gain?
You can try - and this is called "Index Front Running". You can do some research and see how effective the strategy is. My research has shown that Index Trackers have largely caught up with this strategy and try to avoid it by changing exactly when they buy, even at the expense of some temporary tracking error.
Note that not all stocks "just outside the index" get added, so you will largely be guessing on what stocks will actually be included. You will be right on some and wrong on others.
I'm not saying it's a bad strategy, but since it is a known effect, much of it will already be "priced in", and there's less opportunity to capitalize on it.
Shouldn't you purchase some stocks that's just outside the SP500 so that when they're added you can make a gain?
Of course you have no idea when that stock will be added. But if you want to try and time the market, by guessing that a change is imminent, and then buying shares, and selling on the spike; that is a method.
Doesn't that mean when you purchase index funds, you are significantly overpaying for some stocks?
Lets say this is a weakness of investing in an index fund. And lets also assume that your proposed idea is valid and would work. Still over the long term active funds under-perform the index funds. So I don't think there is a fund manager making significant use of this idea.
If a index fund is exactly following the index then they won't purchase shares in non-index companies until the index changes; but if the fund doesn't exactly follow the index they could wait until the spike in price dissipates, and then buy the shares.
