For millions of people around the world, investing in stocks no longer involves picking individual
companies or hiring a portfolio manager to pick them for you.
It means investing in an index fund.
With index funds, there is no portfolio manager, buying the good stocks and selling the bad
ones.
Index funds are “passively managed,” meaning that they buy and sell stocks only when those
stocks are added or removed from the index they track, like the S&P 500.
Passive investors get the return of the overall stock market by investing this way rather
than trying to beat the market and risk underperforming it.
This isn’t what these indices were originally designed for though.
The first stock market index – The Dow Jones Transportation index was formulated 137 years
ago by the editor of the Wall Street Journal.
It was used solely for informational purposes – as an economic indicator to be published
in the newspaper, but those days are long gone.
Today around 11 trillion dollars is invested in index funds, up from around $2 trillion
a decade ago.
And since 2019, more money is invested in passive - index funds than in actively managed
funds in the United States.
Thus, for many companies, their largest shareholders are index funds.
These indices are not static though, their component stocks are constantly changing.
This has to happen, as from time-to-time member companies might merge with each other, go
private or shrink in size – leaving a gap in the index.
Other small companies grow and can be added to replace the stocks that leave.
General Electric – for example, had the longest presence of any company in the Dow
Jones Industrial average, having been added at the start of the index in 1896 only to
be removed 122 years later in 2018, replaced by Walgreens.
Today the S&P 500 is the most important stock market index in the world and being included
in the index is obviously a big deal for a company.
Not only because membership provides a certain amount of prestige for company managers, but
also because of the amount of money that tracks the index.
For S&P500 companies, index investors are a stable shareholder base that will hold the
shares no matter what.
Now, what might work well for many investors might not always be good for the broader financial
markets.
And the indexing revolution - as it has grown - has caused some concern.
Analysts at Bernstein have called passive investing “worse than Marxism.”
The investor Michael Burry, has called it a “bubble,” and shortly before his death
in 2019, John Bogle (the father of index investing) warned that index funds’ dominance might
not “serve the national interest.”
One big concern relates to market signals and capital allocation.
Active managers direct investment to companies based on those companies’ financial prospects.
They hire analysts who study the R&D activity, competitive position, regulatory outlook,
and so on for individual companies.
Using this information, they decide on whether they should buy or sell shares.
If a company’s stock price falls when it announces big losses, that’s because active
investors are selling.
If a company’s shares rocket when it announces a new innovative product, that’s because
active investors are buying.
Additionally active investors might pay more attention when voting on corporate actions
than passive investors do.
Passive investors, by contrast, ignore annual reports and market rumors.
They make no attempt to research what to invest in and what to avoid, they just mirror the
market with a belief that the stocks they buy are fairly valued due to the effort put
in by active investors.
Big U.S.-stock index funds buy big U.S. stocks just because they’re big U.S. stocks and
they are in the index being tracked.
So how do companies get added or removed from indices?
You’d probably assume, that to be included in the index, a company would need to meet
certain requirements.
And, on paper at least, you’d be right.
You can find the list of requirements for index membership in the methodology paper
published on S&P’s website.
It lists conditions such as free float, profitability and market capitalization that make a company
eligible.
You might additionally assume that in order to remain in the S&P500, companies would need
to meet those requirements every time the index is rebalanced, or risk being excluded.
In reality, the S&P 500 doesn’t work that way, there’s a certain amount of discretion
applied for both index adds and deletes.
When AIG was bailed out in the fallout of the financial crisis, for instance, it wasn’t
excluded from the index despite the company’s valuation, and government ownership, not meeting
the published standard.
Excluding AIG during a financial crisis might have been a destabilizing decision at the
time, but it’s not the only example of the rules being selectively applied by S&P’s
index committee.
Now, just to be clear, it might make sense to have a discretionary overlay, especially
when so much money tracks the index, constant changes could be disruptive to the market,
impose trading costs and capital gains taxes on the public.
When indexes rebalance, many active investors buy and sell ahead of the index changes to
profit from the movements of the herd.
Profits earned by these traders come out of the pockets of index fund investors.
If S&P minimize the number of changes, they reduce those costs for index fund investors.
The choice of an index add is not always obvious prior to its announcement, as there are often
over 100 companies large enough to be admitted and S&P picks among them with a balance of
industries in mind.
In fact, in some respects the index is actively managed, requiring companies to demonstrate
profitability in most, but not all circumstances - the popular biotech company Vertex was admitted
in 2013, in spite of a long history of losses, for example.
Google’s class A shares were allowed to remain in the index when a new (more liquid)
share class was introduced a few years ago.
The historic rule of one share class per company was changed to prevent needless buying and
selling.
Today, the S&P contains 505 different stocks but only 500 companies because it includes
two share classes of stock from 5 of its component companies.
Now, a more mechanical approach is taken with the Russell 2000, the most widely followed
index of US smaller companies where the components are selected by a formula and not by a committee.
The reconstitution takes place once a year on the last Friday of June, forcing all active
and passive managers to devote attention to one very large, transparent trading event.
So, what other things might affect S&P index membership?
Well, a new working paper titled “Is Stock Index Membership for Sale?”, offers an additional
possible selection criteria.
The paper found that major U.S. corporations that purchase bond ratings from S&P Global
have a higher chance of being added to the S&P 500 Index -- even when they don’t meet
all of the stated criteria for inclusion.
The paper, published by the National Bureau of Economic Research, (a non-profit network
of economists that regularly circulates working papers to foster debate.)
suggests that companies might be aware of this and possibly seek to curry favor with
the index provider by buying additional services close to the selection dates.
In a statement to the press, S&P Global described the working paper as “flawed”, stating
that the two arms of the business are separate “with policies and procedures in place to
ensure [that] they are operated independently of one another,”
Now of course, in their defense, a growing company can be expected to solicit a credit
rating in order to finance expansion efforts – and this expansion could help the firm
graduate into the index on its own merit.
To obtain a rating, corporate borrowers pay an agency such as S&P Global Ratings to assess
their creditworthiness.
The paper finds though that when an opening is expected in the index, potential entrants
tend to acquire more ratings from S&P -- but not from rival bond rating services like Moody’s,
which isn’t a major index provider.
The researchers noted that: “To rule out the possibility that firms buy more ratings
merely because they wish to issue more bonds for expansion, rather than to curry favor
with S&P, we control for both their bond issues and purchase of Moody’s ratings in all regressions.”
S&P uses a high degree of discretion to decide which firms are included, according to the
researchers.
They found that the published criteria justify only about 62% of the index members positions
during the period studied and just 3% of additions.
Those percentages are far lower than for the Russell 1000 Index, they said.
“S&P appears to deviate from its published criteria in its decisions on adding firms
to its index much more than Russell does,” according to the paper.
This is of course a sensitive topic for ratings companies, who came under fire after the global
financial crisis from critics who argued that they gave risky bonds higher ratings than
they deserved to maintain good ties with the corporate issuers paying them.
As recently as 2020, Morningstar, agreed to pay $3.5 million to settle with SEC over a
conflict-of-interest matter.
In its governance framework, S&P Global sets out “clear separation of distinct functions
and duties across the organization,” according to its website.
“This ensures effective conflicts of interest mitigation and management,” it says.
The researchers see potential economic downsides for those tracking the S&P 500 if less eligible
firms are included in the index.
Companies that edge out better-qualified peers to enter the index fare worse in subsequent
years, the paper said.
Without naming any specific examples, the study says that such firms see on average
a 14.6% drop in profitability and a 37% decline in return on assets in the four years after
entry compared to similar stocks that remain excluded.
They also invest about 13% more in the two years after entry, echoing concerns that entry
into an index loosens shareholder shackles over corporate decisions that may prove costly.
“Their relative advantage in cost of capital and investment suggests possible misallocation
of resources in the economy induced by S&P’s discretion in its index membership decisions,”
the paper said.
OK, so if it is true that companies do pay to be included, how much should they pay?
What is it worth for a company to be included in the S&P500?
You might expect it to be quite valuable, after all, corporate executives do freely
admit to planning and timing corporate actions like acquisitions, divestitures, and other
strategic moves around the effect their actions may have on gaining or preserving membership
in an important equity index.
According to research by McKinsey, gaining entry to or being excluded from a major index
does indeed move a company’s share price.
But they also found that this move is short-lived, and inclusion in a major index is not a factor
in a company’s long-term market valuation.
We know that there is a pop when a company is added to an index, and a price decline
when it is removed, but McKinsey analyzed the longer-term price effect of the inclusion
of 1032 US-listed stocks in the S&P 500 to see whether a place in the index creates a
lasting price premium.
As expected, they did find a pop in price upon inclusion, but the excess return disappeared
within 45 days after the effective date.
In terms of statistically significant positive returns, the effect disappears even sooner—after
20 days.
This result is consistent with the idea that liquidity pressure drives up share prices
initially as investors rebalance their portfolios but, prices then normalize once portfolios
have been rebalanced.
In the end, there was no permanent price premium for companies that had been added to the S&P.
This shows that the value of a stock is in the long run is tied more to the overall business
quality, than membership in a major equity index.
McKinsey also looked at deletions from the S&P 500 finding a similar pattern of temporary
price changes around the announcement.
The price pressure following exclusion from the S&P 500 faded after 40 to 50 days.
If there is no lasting effect associated with index membership, executives should not in
any way adjust their behavior in order to gain inclusion – they should make the best
business decisions they can and not concern themselves with S&P.
If you found this interesting, you should enjoy my recent piece on a SPAC that got in
trouble with the SEC for making misleading claims to investors.
See you soon, bye!