Strategies for stocks that are included in Benchmark Indices

I am going to sound caution on one startegy that is popularly believed to be working. At the same time, I shall attempt to give one that is working. The most popular strategy is to buy (or go long on) stocks when the announcement of introduction into indices is made. By the time they are introduced, the stocks should have appreciated. To check this, I have taken the last seven inclusions and put the theory to test. Incase of Unitech, Rcom & NTPC, the returns in the interim period have been phenomenal. Unitech gave 17%, NTPC gave 19% and RCom gave 21%. But when you consider Suzlon and Siemens, the stocks that lost about 30% in the interim period, the theory goes for a toss. Hence, caution is advised in this startegy.

I have looked at the five day returns of inclusions after they form a part of Nifty and this gives a strategy one can follow. Unitech has given a return of 4% in five days, NTPC 4.8%, Sterlite 6.2%, RPL 2.5%, RCom 5.5%, Suzlon 19.2%, Siemens 5.2%. This is said to be because of three reasons:
1. Buying from Index funds:
Index funds buy new inclusions so as to decrease the tracking error of the fund. The argument against it is that the total corpous of Index fund is just over Rs 3,300 crores which cannot significantly affect the pricing of the inclusions, especially when they have high free float (Cairn has 30% and Idea has 40%).
2. Decrease in Risk premium:
The risk premium on the inclusions would come down as analysts and fund managers, through their research, decrease information assymetry in the market.
3. Buying from broader market players:
Inclusion in a bench mark index is a positive signal for the stocks as they have gone through rigorous filters to end up there. The signal is taken by retail investors who flock to buy these stocks thus adding to the upward pressure in stocks.

Misconception about price retracement:
I have to add my observation about price retracement in index inclusions. The research paper from S. Gowri Shankar & James M. Miller titled “Market Reaction to Changes in the S&P SmallCap 600 Index” indicates that the price of the stock retraces in 60 days. This may be true for madcap & smallcap indices but for a benchmark index like Nifty. I have looked at the stock prices of Unitech, NTPC and RCom. They have never seen the prices they had on the announcement day.
Misconception about exclusions:
The belief is that the stock that is excluded from the indices udergoes a downward price revision. The reason popularly quoted is that the risk premium to hold these stocks goes up as the coverage on these stocks decreases. However, there is no evidence that such a thing happens.