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How to profit by turning the FTSE changes on their heads

TOMORROW evening after the market close the FTSE 100 will undergo its quarterly reshuffle, which sees the UK&rsquo;s leading blue-chip index updated to reflect fully the changing market capitalisation and liquidity of Britain&rsquo;s listed companies.<br /><br />While the process is deliberately as transparent as possible and well publicised in advance in order to minimise any dramatic share price movements ahead of the rejig, pension funds and investment trusts which have FTSE 100 tracker products still need to adjust the weighting of their portfolios to take account of the entrants and leavers.<br /><br />Companies outside the FTSE 100 that grow to rank among the 90 largest by market capitalisation are automatically promoted, while the FTSE 100 firms with the lowest value or that fall to 111th spot or below drop into the FTSE 250.<br /><br />On the cards for entering the top flight this quarter are property investment group Segro, pest control group Rentokil &ndash; which has seen its shares treble in value since the start of the year &ndash; and fund group Investec, while luxury fashion group Burberry is expected to replace Thomson Reuters, which is delisting. Those expected to join the ranks of the FTSE 250 are water utility Pennon Group, which owns South West Water and which has suffered from stricter price controls, as well as engineering firm Balfour Beatty and Foreign &amp; Colonial Investment Trust.<br /><br />The rule of thumb in the markets is typically to buy the FTSE 100 entrants and sell the leavers. However, given that the FTSE Group announces a reshuffle two weeks before the changes are announced and take effect, big funds and trusts will not leave it until the last minute to make their changes, so there is limited volatility and price jumps for traders to take advantage of.<br /><br />Traders who have not already made their moves might think that they are too late. But the reshuffle still offers opportunities for contracts for difference (CFDs) traders in the coming days. Richard Perry, chief market strategist at CFD provider Central Market suggests a more counter-intuitive strategy that traders could look to employ in the wake of the reshuffle.<br /><br />&ldquo;All this forced trading can send the shares to artificial high or low levels. Therefore, in the case of the drop-outs, as this selling pressure subsides, theoretically the price will begin to rally as the shares unwind this artificially low level. So on leaving the FTSE 100, the former constituents should see a rise in their share price,&rdquo; he says.<br /><br />The opposite should be the case for the newly promoted FTSE 100 stocks as the buying pressure comes to an end, forcing the artificially high share price to unwind, and leading to a decline in the price.<br /><br />For example, Rentokil might have had an excellent first half of 2009 but the share price is taking into account a lot of good news that may or may not materialise and is also looking a bit toppy at current levels.<br /><br />Perry notes that in March a quantitative research team at HSBC did an analysis of the historical trends of the reshuffle. The team concluded that since 2003 this strategy of selling the promoted and buying the fallers has had an 86 per cent success rate. Proof, as if any were needed, that following the crowd is not always the best method of trading.