Google’s stock price (GOOG $408) shot up almost 7% to $366 on March 24, the day after it was announced that the company would be added to the S &P 500 Index. There had been speculation for many months about the company’s inclusion in the prestigious index. The company’s large market cap of more than $100 billion and pre-eminence in a growth industry made it a natural selection. Nonetheless, investors jumped on the news, which, in combination with some improved fundamentals and better analysts’ reviews, sent the stock sharply higher.

There are those who spend much time speculating about which company will be the next to get elite 500 status. The requirements for inclusion are vague and the selection process opaque. There are guidelines, such as a required market cap of at least $4 billion, a certain measure of liquidity, and financial viability, but the decision on which sector will get the nod, or which company, is in the hands of a committee that meets monthly and reviews possible candidates.

Though managements have been known to meet with the committee, anxious to be added to the list, and though there are investment banks who may suggest that they can speed the process along, Standard & Poor’s maintains that the inclusion is made without outside influence. They especially dislike the “beauty pageant” analogy.

Why is being posted to the S &P 500 such a big deal? More than $1.1 trillion of assets is invested in index funds, ETFs, or other vehicles that attempt to replicate the S &P 500,mainly by buying shares in the index companies. Another $4 trillion is invested in pools of money that use the S &P 500 as a benchmark. There are also funds that are only allowed to invest in companies in the index. In other words, the stakes are high.

It is widely perceived that a stock will go up once it is added to the list. However, notwithstanding the Google experience, the impact appears to be waning. On Tuesday S &P announced that money manager Legg Mason (LM $122) was joining the 500; the stock actually dropped in price the next day.

Analysts David Blitzer and Srikant Dash of Standard & Poor’s would not be surprised by Legg Mason’s experience. The duo wrote a report in late 2004 that detailed how “excess returns have diminished sharply” as a result of index inclusion. While being added to an index back in the late 1990s typically boosted the share price of a company by almost 9%, that increase had dwindled to less than 4% between 2002 and 2004.This is the case despite continued growth in assets being managed in index funds and, more recently, in ETFs.

Why should the index effect have softened? And does the Google experience argue otherwise? How does it work?

There are several reasons cited for the lower “post-inclusion pop” in recent times. First, like most other obvious trading games, a rise in the number of players has narrowed the arbitrage opportunity. It rarely takes long for a trading pattern to be recognized, and for new participants to take a seat.

Second, index fund managers have devised an increasing number of strategies to avoid having to quickly load up on new stocks added to the index. Funds can make arrangements with brokers who buy shares in advance, or can take days or even weeks to fill out their positions, while relying on futures to supply any needed exposure in the meantime.

This is not to say that the funds will not ultimately buy the shares. It is still the case that about 11% of the outstanding shares of a company in the S &P 500 index is owned by index funds. This figure is actually up slightly over the past six years, reflecting the continuing growth of assets invested in index funds.

Third, increased investment dollars tied to funds mimicking the smaller cap indices has a cushioning effect. As companies like Legg Mason move from the smaller-cap to the large-cap index, managers of the small-cap funds have to sell while those running S &P 500 funds have to buy. This is a blunting factor, not a wash, since there is substantially more money tied to the S &P 500 than to mid- or small-cap indices.

Since Google moved into the index after only two years as a publicly held stock, this offset did not come into play, which might be one reason that Google’s shares jumped as much as they did.

New membership in the index still boosts trading volume in the newly added shares to almost four times the normal level on the day after the announcement, and to more than 15 times on the effective date of the change. That is, there is still a huge amount of repositioning going on, but the price impact has been blunted by the factors already mentioned. In response, companies are now often issuing shares to resolve any liquidity issues.

Not every index fund owns each stock in the index. The funds do not necessarily replicate the S &P index; rather, they try to copy the performance of the index. Most index funds promise to hold about 80% of assets in the stocks of the index. That leaves them plenty of opportunity to use derivatives products to achieve index-like performance, while delaying the outright purchase of a newly added stock.

Notwithstanding the diminished impact of inclusion, managements are eager to have their stocks represented in the S &P index. This ambition is more than a vanity point. Not only is there some boost in the demand for a company’s shares, but the index funds also tend to be fairly stable owners. Other than the occasional sale to provide for client redemptions, it can be assumed that at least 11% of a company’s shares are in steady hands.

How does Standard & Poor’s go about making their selections? About 70%-80% of new additions come about because of mergers or acquisitions. For example, Google replaced Burlington Resources, which is being bought by ConocoPhillips. More than half of the additions to the 500 have come from the smaller-cap indices. A spokesman for Standard & Poor’s argues that adding a company to the list does not imply any view of the investment merits of the firm. What it does signal is somewhat mysterious, and will no doubt continue to provide fodder for speculation.

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