S&P 500 Membership May Be ‘For Sale,’ NBER Research Suggests
(Bloomberg) -- A new study has made explosive claims about the world’s largest stock benchmark: Major U.S. corporations that purchase ratings from S&P Global Inc. have a higher chance of entering the S&P 500 Index -- even when they don’t meet all criteria for inclusion.
The study titled “Is Stock Index Membership For Sale?” threatens to fuel controversy over the far-reaching impact of the gauge tracked by more than $13 trillion in capital. With every adjustment moving billions of dollars around the world, inclusion is a game-changer for boardrooms across America.
“The S&P has likely exercised a nontrivial amount of discretion in deciding which firms to add to the index,” authors Kun Li and Xin Liu at ANU and Shang-Jin Wei at Columbia wrote in the study. “Data patterns suggest that the discretion is often exercised in a way that encourages firms to buy fee-based services from the S&P.”
In a statement, S&P Global described the working paper as 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,” it said. “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 U.S. large cap equity market.”
At first blush, there’s an easy explanation for the study’s results: A growing company solicits a credit rating in order to finance expansion efforts -- a move that can 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 three authors found that when an opening is expected on the S&P 500, potential entrants tend to acquire more ratings from S&P -- but not those from rival Moody’s Investors Service, which isn’t a major index provider. That’s especially the case when recent additions enjoy big price jumps, making inclusion ever-more attractive.
The index provider uses a high degree of discretion to decide which firms get in, the researchers said. They found official S&P 500 criteria explained only about 62% of membership of the gauge in the period studied and just 3% of additions. Those percentages are far lower than for the London Stock Exchange’s 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,” the paper said.
It all adds to the debate over the extraordinary power wielded by index providers in modern markets. Roughly $5.4 trillion of assets directly track the S&P 500, while another $8 trillion use it as a benchmark, according to S&P estimates.
S&P Global’s own research has argued that the impact on the share prices of companies joining the S&P 500 -- the so-called index effect -- has dwindled in recent years. In other words, there’s less incentive for a firm to try to win admission to the gauge.
Meanwhile, a discretionary element to S&P 500 inclusion is openly acknowledged by the benchmark provider. Company size is a major factor, as is liquidity and profitability, with the final decision taken by an index committee. Tesla Inc. famously slumped when it was left out of the benchmark in one quarterly reconstitution, even though it had seemed to meet requirements. Three months later, it finally made it.
The index committee aims to minimize turnover and also take sector representation into account, according to the firm’s methodology. Shifts in index composition are made as needed and “changes in response to corporate actions and market developments can be made at any time,” it says.
In the paper, Li, Liu and Wei said it’s unclear whether and how executives and employees in other parts of the company interact with the committee.
“As of now, the existing literature still has not investigated the objectivity of the index composition and the possible conflict of interest in the membership decisions on the most tracked stock index,” they wrote.
It’s a sensitive topic for ratings companies, who came under fire after the global financial crisis from critics who argued they gave risky debt securities higher ratings than deserved to maintain good ties with the corporate issuers paying them.
As recently as 2020, another firm, Morningstar Credit Ratings LLC, agreed to pay $3.5 million to settle with the Securities and Exchange Commission over a conflict-of-interest matter. The firm settled without admitting wrongdoing.
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 added to the gauge. Companies that edge out better-qualified peers to enter the index fare worse in subsequent years, the paper said.
Without naming any specific examples, it said 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.
The U.S.-based NBER is a non-profit network of economists that regularly circulates working papers to foster debate.
Li and Liu are lecturers of finance at ANU. Wei is a professor of finance and economics at Columbia who has served as chief economist of the Asian Development Bank.
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