Index rebalance saves Lake Resources from brutal selloff: Is the index effect real?

Lake Resources (ASX: LKE) and Core Lithium (ASX: CXO) are two names that have managed to withstand the brutal selloff sweeping the S&P/ASX 200 on Tuesday.

In particular, the strength behind Lake Resources has been extraordinary.

• Open: $1.305 (-6.8%)

• Intraday low: $1.30 (-7.1%)

• Intraday high: $1.62 (15.7%)

• Close: $158 (12.9%)

The likely catalyst behind their outperformance - index rebalancing.

Lake Resources and Core Lithium, along with Brainchip Holdings (ASX: BRN) and New Hope (ASX: NHC) will be added to the ASX 200, effective prior to the open of trading on Monday, 20 June. 

In this piece, we explore what's behind the index rebalancing phenomenon and whether or not it could be used as a viable trading strategy.

Yes but no

A 2019 research paper by Ivaylo Dimitrov studied the index effect for changes in the S&P/ASX 20, 50 and MidCap 50.

The research used 43 events for the ASX 50 for the period 1994 to 2018. The MidCap 50 included 117 inclusions and 64 exclusions.

Note: the MidCap 50 includes stocks in the ASX 100 but excludes those in the ASX 50

The paper did not find any significant cumulative average abnormal returns (CAARs) for MidCap 50 inclusions around the announcement period and the effective date.

However, found significant CAARs for the period prior to the announcement, signifying “participants anticipate the changes to index composition and possibly try to exploit the already established phenomenon that is the index effect.” 

However, such gains were all “fully reversed following the effective date.”

In terms of exclusions, Dimitrov found “significant negative CAARs over the announcement period for all days up to the effective date, which is not reversed in the following 20 days.”

Source: The effect of changes in equity index composition on stock price, Ivaylo Dimitrov (2019)

The bottom line: the index effect has become too popular and an ineffective trading strategy as “market arbitrageurs take advantage of the predictability of the market spur demand for the affected stock, which would revert as soon as the demand is balanced.”

Even then

Lake Resources closed the day 12.5% higher when most of its peers like Allkem (ASX: AKE) and Pilbara Minerals (ASX: PLS) finished around -5% lower.

There seems to be no other viable explanation as to how Lake Resources could have withstood the sheer selling pressure experienced by the market on Tuesday.

Lake Resources expects to begin seeking approvals for its Kachi Project in mid-late 2022 for 2024 production.