A paper suggesting conflict of interest in the S&P 500 stock inclusion process has raised questions about the index's inclusion committee.
The S&P 500 is the world’s most important stock market index. Approximately $14 trillion is benchmarked to the index. The large multi-billion-dollar passive funds from the likes of BlackRock and Vanguard replicate the index, buying a slice of each stock.
So, for a company, being included in this index is a big deal. Therefore, how the index decides on who to award a spot to is important.
To gain access to the S&P 500, a company must meet certain objective criteria. First, it must be deemed a US company, not just a company listed on a US exchange. Second, it must have a market capitalisation of at least around $12 billion. Third, it must have 10% or more of its shares publicly traded. Fourth, its most recent quarterly earnings and the sum of its previous four consecutive quarterly earnings must be positive. The company must also be deemed highly liquid to allow investors to easily buy and sell.
Aside from the profitability requirement, these rules are not that different from other major indices. However, meeting those objective requirements alone is still not enough for inclusion. The composition of the S&P 500 is also determined by decisions made by the so-called Index Committee. This committee is composed of full-time S&P Dow Jones Indices’ staff, who meet monthly. To prevent lobbying, membership of the committee is kept anonymous.
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Therefore, the S&P 500 index is not actually just the top 500 US companies by market cap (that meet certain free float and liquidity requirements, etc). Instead, the index is a selection of US stocks that meet these requirements and have been deemed worthy of inclusion based on the qualitative judgement of the Index Committee. The actual purpose of the index is to provide a sample of “leading companies from leading industries”.
As a result, the index has often been criticised. For example, Robert Arnott notes in his book The Fundamental Index: “The process is subjective – not entirely rules-based and certainly not formulaic.” As a result, he continues, “there are many who argue that the S&P 500 is not an index at all: it is an actively managed portfolio selected by a committee – whose very membership is a closely guarded secret!”
Others have also pointed out that the discretionary nature of inclusion has cost investors by delaying the introduction of Tesla (NASDAQ:TSLA) and other companies in the past. However, other voices counter that the difference between the S&P 500 and the actual largest 500 listed companies in the US is generally quite small.
In other instances, the discretionary nature of the index can help protect investors. For example, as I recently observed, the strange meme-stock phenomenon meant GameStop (NYSE:GME) reached the market cap requirement for S&P 500 inclusion. However, the Index Committee is unlikely to allow the company into the index anytime soon, owing to their (presumed) qualitative judgement that the company’s share price has increased for odd and unsustainable reasons. Time will tell whether this decision is correct.
However, a new concern has been introduced to the whole S&P discretionary Index Committee debate. Recently, a new working paper (not peer reviewed) titled Is Stock Index Membership for Sale? was released from the National Bureau of Economic Research. As the title suggests, the academics working on the paper allege that inclusion in the index may be influenced by a company’s commercial relationship with S&P.
Alongside creating and maintaining indices, S&P Dow Jones also sells bond ratings to companies. Companies issuing bonds will go to the S&P, or some other competing firm, such as Moody’s or Fitch, and pay them to provide a rating for their bond. This gives the bond credibility in the market.
But according to the new academic paper, there is a correlation between companies using S&P for their bond ratings and inclusion in the index. The paper makes three broad claims:
- A company buying ratings from S&P statistically increases its likelihood of entering the index
- Companies tend to buy more ratings from S&P when there is an opening in the index membership
- When S&P changed the rules in 2002 excluding foreign companies from the S&P 500, the no-longer eligible companies bought less S&P ratings than before
The implication here is that the S&P 500 index selection committee may be using its discretionary power to reward firms that bring other parts of the S&P lots of business. Index inclusion is “pay to play”. That is obviously a very serious allegation and S&P vehemently denies it. S&P said: “This non peer-reviewed paper is flawed. S&P Dow Jones Indices and S&P Global Ratings are separate businesses with policies and procedures to ensure they are operated independently of one another. Our Index Governance segregates analytical and commercial activities to protect the integrity of our indices. For 64 years, the S&P 500 has provided an independent, transparent and objective benchmark of the US large-cap equity market.”
It also seems fairly unlikely. Surely, S&P and the Index Committee know the unique and immensely powerful brand that is the S&P 500. As noted above, trillions of dollars is benchmarked to the index. It’s a huge business entirely based on the reputation of the index’s brand. Leveraging to bring in more business for bond ratings seems woefully short-sighted. If it were proven that the S&P had some kind of “pay to play” arrangement, fund providers would quickly change their benchmarks.
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There is also the fact that the two different arms of the business are separate from one another to prevent this type of conflict of interest. The Index Committee members, in theory, do not have regular contact with salespeople from the bond rating part of S&P. Members being pressured by bond ratings salespeople seems far-fetched.
A more generous interpretation is that companies mistakenly believe that using S&P’s bond ratings service increases their chances of index inclusion. There may be no actual mechanism for bond rating sales to translate into index inclusion, but the perception of there potentially being one could be enough to drum up sales. For a company that has met all the objective criteria for inclusion in the S&P 500, using S&P rating services over Moody’s or Fitch probably seems like a worthwhile punt.
But while it seems doubtful that the S&P 500 is being used to drum up S&P’s bond rating business, the whole debate does raise other questions about the power of index providers.
The rise of passive investing over the past few decades has been an undoubted boon to investors, saving them untold amounts in fees and active manager underperformance. But it has led to a strange situation where index providers have gained immense power. Index providers have gone from being data companies that provide a snapshot of the general direction of financial markets, to controlling the flow of trillions of dollars in those markets.
In effect, the world’s biggest investors are delegating their investment decisions to these companies. As Robin Wigglesworth from the Financial Times has pointed out: “Financial indices are arguably the most under-appreciated force shaping global markets”.
These questions, however, are for policymakers and economists to grapple with in future.
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