For millions of people around the world, investing in stocks no longer involves picking individual
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.
companies or hiring a portfolio manager to pick them for you.

It means investing in an index fund.
It means investing in an index fund.

With index funds, there is no portfolio manager, buying the good stocks and selling the bad
With index funds, there is no portfolio manager, buying the good stocks and selling the bad

ones.
ones.

Index funds are “passively managed,” meaning that they buy and sell stocks only when those
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.
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
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.
than trying to beat the market and risk underperforming it.

This isn’t what these indices were originally designed for though.
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
The first stock market index – The Dow Jones Transportation index was formulated 137 years

ago by the editor of the Wall Street Journal.
ago by the editor of the Wall Street Journal.

It was used solely for informational purposes – as an economic indicator to be published
It was used solely for informational purposes – as an economic indicator to be published

in the newspaper, but those days are long gone.
in the newspaper, but those days are long gone.

Today around 11 trillion dollars is invested in index funds, up from around $2 trillion
Today around 11 trillion dollars is invested in index funds, up from around $2 trillion

a decade ago.
a decade ago.

And since 2019, more money is invested in passive - index funds than in actively managed
And since 2019, more money is invested in passive - index funds than in actively managed

funds in the United States.
funds in the United States.

Thus, for many companies, their largest shareholders are index funds.
Thus, for many companies, their largest shareholders are index funds.

These indices are not static though, their component stocks are constantly changing.
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
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.
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.
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
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
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.
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
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.
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
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.
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
For S&P500 companies, index investors are a stable shareholder base that will hold the

shares no matter what.
shares no matter what.

Now, what might work well for many investors might not always be good for the broader financial
Now, what might work well for many investors might not always be good for the broader financial

markets.
markets.

And the indexing revolution - as it has grown - has caused some concern.
And the indexing revolution - as it has grown - has caused some concern.

Analysts at Bernstein have called passive investing “worse than Marxism.”
Analysts at Bernstein have called passive investing “worse than Marxism.”

The investor Michael Burry, has called it a “bubble,” and shortly before his death
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
in 2019, John Bogle (the father of index investing) warned that index funds’ dominance might

not “serve the national interest.”
not “serve the national interest.”

One big concern relates to market signals and capital allocation.
One big concern relates to market signals and capital allocation.

Active managers direct investment to companies based on those companies’ financial prospects.
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,
They hire analysts who study the R&D activity, competitive position, regulatory outlook,

and so on for individual companies.
and so on for individual companies.

Using this information, they decide on whether they should buy or sell shares.
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
If a company’s stock price falls when it announces big losses, that’s because active

investors are selling.
investors are selling.

If a company’s shares rocket when it announces a new innovative product, that’s because
If a company’s shares rocket when it announces a new innovative product, that’s because

active investors are buying.
active investors are buying.

Additionally active investors might pay more attention when voting on corporate actions
Additionally active investors might pay more attention when voting on corporate actions

than passive investors do.
than passive investors do.

Passive investors, by contrast, ignore annual reports and market rumors.
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
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
market with a belief that the stocks they buy are fairly valued due to the effort put

in by active investors.
in by active investors.

Big U.S.-stock index funds buy big U.S. stocks just because they’re big U.S. stocks and
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.
they are in the index being tracked.

So how do companies get added or removed from indices?
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
You’d probably assume, that to be included in the index, a company would need to meet

certain requirements.
certain requirements.

And, on paper at least, you’d be right.
And, on paper at least, you’d be right.

You can find the list of requirements for index membership in the methodology paper
You can find the list of requirements for index membership in the methodology paper

published on S&P’s website.
published on S&P’s website.

It lists conditions such as free float, profitability and market capitalization that make a company
It lists conditions such as free float, profitability and market capitalization that make a company

eligible.
eligible.

You might additionally assume that in order to remain in the S&P500, companies would need
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.
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
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.
applied for both index adds and deletes.

When AIG was bailed out in the fallout of the financial crisis, for instance, it wasn’t
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
excluded from the index despite the company’s valuation, and government ownership, not meeting

the published standard.
the published standard.

Excluding AIG during a financial crisis might have been a destabilizing decision at the
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
time, but it’s not the only example of the rules being selectively applied by S&P’s

index committee.
index committee.

Now, just to be clear, it might make sense to have a discretionary overlay, especially
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,
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.
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
When indexes rebalance, many active investors buy and sell ahead of the index changes to

profit from the movements of the herd.
profit from the movements of the herd.

Profits earned by these traders come out of the pockets of index fund investors.
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.
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
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
over 100 companies large enough to be admitted and S&P picks among them with a balance of

industries in mind.
industries in mind.

In fact, in some respects the index is actively managed, requiring companies to demonstrate
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
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.
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)
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.
share class was introduced a few years ago.

The historic rule of one share class per company was changed to prevent needless buying and
The historic rule of one share class per company was changed to prevent needless buying and

selling.
selling.

Today, the S&P contains 505 different stocks but only 500 companies because it includes
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.
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
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.
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
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.
and passive managers to devote attention to one very large, transparent trading event.

So, what other things might affect S&P index membership?
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
Well, a new working paper titled “Is Stock Index Membership for Sale?”, offers an additional

possible selection criteria.
possible selection criteria.

The paper found that major U.S. corporations that purchase bond ratings from S&P Global
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
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.
all of the stated criteria for inclusion.

The paper, published by the National Bureau of Economic Research, (a non-profit network
The paper, published by the National Bureau of Economic Research, (a non-profit network

of economists that regularly circulates working papers to foster debate.)
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
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.
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
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
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,”
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
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
rating in order to finance expansion efforts – and this expansion could help the firm

graduate into the index on its own merit.
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
To obtain a rating, corporate borrowers pay an agency such as S&P Global Ratings to assess

their creditworthiness.
their creditworthiness.

The paper finds though that when an opening is expected in the index, potential entrants
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,
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.
which isn’t a major index provider.

The researchers noted that: “To rule out the possibility that firms buy more ratings
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
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.”
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
S&P uses a high degree of discretion to decide which firms are included, according to the

researchers.
researchers.

They found that the published criteria justify only about 62% of the index members positions
They found that the published criteria justify only about 62% of the index members positions

during the period studied and just 3% of additions.
during the period studied and just 3% of additions.

Those percentages are far lower than for the Russell 1000 Index, they said.
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
“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.
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
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
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.
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
As recently as 2020, Morningstar, agreed to pay $3.5 million to settle with SEC over a

conflict-of-interest matter.
conflict-of-interest matter.

In its governance framework, S&P Global sets out “clear separation of distinct functions
In its governance framework, S&P Global sets out “clear separation of distinct functions

and duties across the organization,” according to its website.
and duties across the organization,” according to its website.

“This ensures effective conflicts of interest mitigation and management,” it says.
“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
The researchers see potential economic downsides for those tracking the S&P 500 if less eligible

firms are included in the index.
firms are included in the index.

Companies that edge out better-qualified peers to enter the index fare worse in subsequent
Companies that edge out better-qualified peers to enter the index fare worse in subsequent

years, the paper said.
years, the paper said.

Without naming any specific examples, the study says that such firms see on average
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
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.
entry compared to similar stocks that remain excluded.

They also invest about 13% more in the two years after entry, echoing concerns that entry
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.
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
“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,”
of resources in the economy induced by S&P’s discretion in its index membership decisions,”

the paper said.
the paper said.

OK, so if it is true that companies do pay to be included, how much should they pay?
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?
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
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
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
strategic moves around the effect their actions may have on gaining or preserving membership

in an important equity index.
in an important equity index.

According to research by McKinsey, gaining entry to or being excluded from a major index
According to research by McKinsey, gaining entry to or being excluded from a major index

does indeed move a company’s share price.
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
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.
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
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
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
of 1032 US-listed stocks in the S&P 500 to see whether a place in the index creates a

lasting price premium.
lasting price premium.

As expected, they did find a pop in price upon inclusion, but the excess return disappeared
As expected, they did find a pop in price upon inclusion, but the excess return disappeared

within 45 days after the effective date.
within 45 days after the effective date.

In terms of statistically significant positive returns, the effect disappears even sooner—after
In terms of statistically significant positive returns, the effect disappears even sooner—after

20 days.
20 days.

This result is consistent with the idea that liquidity pressure drives up share prices
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
initially as investors rebalance their portfolios but, prices then normalize once portfolios

have been rebalanced.
have been rebalanced.

In the end, there was no permanent price premium for companies that had been added to the S&P.
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
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.
quality, than membership in a major equity index.

McKinsey also looked at deletions from the S&P 500 finding a similar pattern of temporary
McKinsey also looked at deletions from the S&P 500 finding a similar pattern of temporary

price changes around the announcement.
price changes around the announcement.

The price pressure following exclusion from the S&P 500 faded after 40 to 50 days.
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
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
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.
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
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.
trouble with the SEC for making misleading claims to investors.

See you soon, bye!
See you soon, bye!