Our main contribution in this paper is to shed novel light on index rebalancings – and especially on the behavior of investors – by combining transaction-level data from the Colombian stock market with episodes of additions into and deletions of Colombian stocks from MSCI indexes. Our dataset contains all the stock purchases and sales from the secondary market where these stocks are traded. Additionally, we observe the individual/institution involved in each transaction. To our knowledge, this is the first attempt to provide a complete picture on index rebalancing episodes by analyzing not only price changes, but also the actual trading behavior of the universe of investors in response to these episodes. Furthermore, our dataset allows us to measure also the demand elasticity for stocks using actual traded quantities, without having to make assumptions on funds’ behavior.

We find that inclusion into an international equity index leads to a median cumulative abnormal return, from the announcement to the implementation date, of 5.5%, which is line with recent studies of equity additions and deletions (Chang et al., 2014). We show that the price effect results from a large increase in the demand by foreign investors.<sup>4</sup> This group buys (sells) about 2.7% of the outstanding shares of stocks included into (removed from) the indexes, with most trades taking place on the effective day of the index recomposition rather than on the announcement day. Such portfolio rebalancings do not revert, at least in the month following the index redefinition. In addition to passive mutual funds and ETFs, most foreign investors – including active mutual funds, pension funds, investment firms, government agencies and sovereign wealth funds – also rebalance their portfolios in the direction of the index. The demand shock from such nonpassive investors is 1.7 times larger than the demand from purely passive funds. Foreign hedge funds, instead, tend to trade in the opposite direction of the index recomposition, possibly to speculate on the events. Yet, their trades are very small compared to those of the rest of foreign investors. Finally, we combine our results on prices and traded quantities and estimate a median elasticity of demand for stocks of -0.34. Thus, for the median stock in our sample, a 1% increase in the quantity demanded of shares (relative to the number of shares outstanding) leads instance, Chang et al. (2014), in their RDD study on the impact of stock inclusions into the Russell 1000 index, and contemporaneous exclusion from the Russell 2000, provide an estimated elasticity between -1.5 and -0.4, which implies that a 1% increase in the quantity demanded of a given stock leads to an increase in its price ranging from 0.67% to 2.5%. The latter is estimated assuming that only passive funds tracking both indexes rebalance their portfolios accordingly. The former is instead obtained under the assumption that all investors (passive and active) benchmarked against these indexes do so.

> 4In emerging markets, MSCI indexes are mostly tracked by foreign investors rather than domestic ones, as they have international focus and often include stocks from different countries. In fact, we show in Section 3 that domestic investors sell stocks when these are included in international indexes and buy them when they get removed.

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