Reddit Joins the S&P 500 Tuesday. Here's What History Says Could Come Next -- and What Investors Should Know.

Reddit (NYSE: RDDT) is going into the S&P 500 (SNPINDEX: ^GSPC). S&P Dow Jones Indices said Thursday evening that the social media company will replace AvalonBay Communities in the index before the market opens on Tuesday, Aug. 18. AvalonBay is leaving because a fellow index member, Equity Residential, is acquiring it.

Investors treated the announcement as a windfall. Reddit shares were up about 13% in Friday trading, near $179.

Even after the jump, the stock sits roughly 37% below its 52-week high of $282.95.

The logic behind the pop is simple enough. Index funds tracking the S&P 500 must buy Reddit shares by Tuesday, and forced buying should push the price up. But is joining the index worth 13% of a company's value? The best research on the subject says the index bump has been shrinking for decades, and that over the most recent one, it essentially vanished.

Image source: The Motley Fool.

The disappearing index effect

In a study titled exactly that, Robin Greenwood and Marco Sammon of Harvard Business School measured the abnormal return (the move beyond what the market would have delivered anyway) for every S&P 500 addition between 1980 and 2020.

The effect wasn't always small. Additions gained an average of 3.4% in the 1980s, and the figure swelled to 7.4% in the 1990s. From there, though, it faded -- to 5.2% in the 2000s, and to less than 1% over the 2010s, a result the authors call statistically indistinguishable from zero. The pattern holds in reverse, too. Getting dropped from the index cost the average deletion 16.1% in the 1990s and just 0.6% in the 2010s.

Companies jumping straight into the index from outside S&P's smaller benchmarks did better, and that's Reddit's situation. But the same decay shows up: direct additions returned 10.2% in the late 1990s, 8.8% in the 2000s, and 5.4% in the 2010s -- and even that number needs an asterisk, because the enormous 2020 inclusion rally in Tesla props it up. Excluding Tesla, the additions of 2020 averaged roughly nothing.

The market adapted

Why did the effect fade? The authors' answer is mostly structural. More additions now migrate up from the S&P MidCap index, where index-tracking money already owns them, so the new buying is smaller than it looks. And the market has become far better at supplying shares when index funds do have to buy. Plenty of investors now stand ready to take the other side of the trade.

Anticipation plays a part, too. The cumulative climb in the stocks that ended up joining, measured across the 100 trading days before the announcement, grew from 9.6% in the 1990s to 18.7% in the 2010s -- though the authors note that could equally reflect the index getting better at adding recent winners.

None of this is to say Reddit's Friday jump will simply reverse. Big inclusion rallies can still happen, as Tesla's once did. But the record says they are the exception now, not the rule -- and that on average, the badge itself has been worth close to nothing once the buying settles.

What the index can't fix

What Reddit keeps from here rides on the business, and the business is a strange mix of dominant and fragile.

The dominant part is easy to see. Revenue has grown more than 60% year over year for eight straight quarters, reaching $2.8 billion over the trailing 12 months. And the company is solidly profitable, with about $871 million of net income over that span.

The fragile part showed up two weeks ago. Reddit's stock sank after management told investors its search referral traffic had been choppy, reviving an old worry: A large share of Reddit's traffic arrives through Google, and Google's AI-generated answers increasingly make searchers less likely to click through.

At about 40 times earnings, Reddit trades at a price that assumes the growth continues. That looked expensive to the market two weeks ago, and an index announcement changes exactly nothing about the user pipeline.

I'd be cautious here.

Daniel Sparks has clients with positions in Tesla. The Motley Fool has positions in and recommends Reddit and Tesla. The Motley Fool recommends AvalonBay Communities. The Motley Fool has a disclosure policy.