Will Index Funds Boost Solar Stocks?

Index funds aren't the most exciting investments in the world. But when new companies get added to an index, shareholders suddenly see their companies in the spotlight -- and then look for ways to profit.

One major player in the index arena, Russell Investments, makes changes to its benchmark indexes each June. Although Russell is perhaps best known for its Russell 2000 index of small-cap U.S. stocks, it also maintains other benchmarks that cover stocks around the world. According to Russell, index funds and other institutional investors have $4.4 trillion in assets tied to its benchmarks. And among this year's proposed new additions, you'll find several well-known solar stocks.

Money for nothing?
With that much money committed to buying shares at any price, many sophisticated investors try to profit from proposed index changes by jumping in ahead of time. Increased demand from these investors may raise share prices. If that happens, index funds are forced to pay more money to buy shares on the date a company is officially added to the index. One study has shown that this very occurrence has cost long-term Russell 2000 investors as much as 1.3% annually.

Unlike other index managers, such as Standard & Poor's, Russell tells the public how it comes up with new companies to add to its indexes. It has even published a list of proposed additions, to be effective after the market closes on June 27. Included on Russell's lists are the following companies:

Source: Russell Investments.

A few solar companies, such as First Solar (NASDAQ:FSLR) and Suntech Power (NYSE:STP), are already included in various Russell indexes. But these additions promise to raise the profile of the solar industry substantially within the investment portfolios of institutions worldwide.

Does it really work?
Getting added to an index does earn companies some attention, but it's unclear whether the attention helps their stocks over the long run. One study recently discussed in The New York Times found that new Russell 2000 stocks do get a nice boost in the days or weeks when they're first added to an index. But in the first year after index changes are made, stocks that are added do worse than stocks that were removed from the index, by 9.3 percentage points. Over the following five years, the difference is an even more pronounced 40.1 percentage points.

In an efficient market, profiting from index additions shouldn't be possible -- especially once enough market participants are aware of the opportunity. Yet this phenomenon shows one of the shortcomings of index funds: They're trapped by their respective benchmarks. Rather than make rational investment decisions that change with share prices, they're evaluated solely on their ability to track an index. And because the index's own performance is also affected, the effect of this forced buying on overall returns is largely hidden.

Be smart
Regardless of what you think about solar stocks, their addition to Russell indexes probably won't have a huge impact on the solar industry. Those who believe in the huge potential for solar in the future shouldn't get distracted by the chance to make a quick buck from these changes. If solar stocks realize that potential, any gains from index-fund demand will be tiny compared with the growth long-term investors see.

For more on solar stocks, read about:

• How big the solar industry may get in the coming years.
• The latest report from the world of solar energy.
• An ETF that's poised to profit from solar.