In order for a market to function efficiently it needs to be liquid, In other words there must be sufficient buyers and sellers to enable the market to function appropriately. In every market and no less stock indices, the price of an asset is representative of what a buyer or a seller is willing to buy or sell the asset. If the market is not liquid, then the price is meaningless, because there are not any buyers or sellers, to transact at this price. There are times during the life of a market when the market simply disappears and this could happen daily rather than once a month.
Market liquidity has implications for stock indexes and the construction of indexes because if the prices of the stocks that make up the index are not real or trades can’t be completed then the function of the stock index to track the stock market becomes almost impossible. The stock index remains a sentiment indicator but can’t support and reflect actual transactions. This can be a problem for retail traders who trade stock indexes through online trading; particularly the incomplete trade because the investor can’t trade at the price quoted. In other words if a market is liquid investors and traders can execute their trades at the prices quoted or at the very least very close to that price. For small amounts of stock this is not a problem but for an investor transacting thousands of shares it is a real problem.
Even seasoned investors believe that the sophisticated well developed markets of the major financial centers such as London and New York never have a liquidity problem. However, they do because from time to time there are adjustments in indices as stocks are taken out and others are put in. There is the phenomenon of the so called ‘index effect’ and unless the authorities that construct the indices are careful to check liquidity before making adjustments there will be a liquidity problem.
What the ‘index effect’ does to liquidity depends on the change. The addition of a stock usually leads to greater returns closely following the announcement followed by an additional rise till the actual change. On the other hand, deletions lead to substantial negative returns that last until after the change date. Traded volumes surge considerably and continue at high levels later than the change date for the supplementary stocks.
The authorities who decide on the stock components of the S&P 500 index have recognized that there could be an ‘index effect’ and give ample notice to the market about any component changes, as well as looking very carefully at days where they know there is not a liquidity problem so are able to make changes without adverse liquidity effects; such as mid-week, when trading is more liquid. They always avoid days when there are stock splits and other such events. In addition they are consistent in using closing prices as the basis for their adjustments and calculations.