S&P 500 membership could be ‘for sale’, NBER study suggests

(Bloomberg) – New study has made explosive claims about the world’s largest stock market benchmark: Large US companies that buy ratings from S&P Global Inc. are more likely to enter the S&P 500 index – even when they do not meet all the inclusion criteria.

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The non-peer reviewed article by academics at Australian National University and Columbia University, published by the National Bureau of Economic Research, suggests that companies are seeking to curry favor with the index provider by purchasing additional services.

The study titled “Is Stock Market Index Membership for Sale?” Threatens to fuel controversy over the far-reaching impact of the gauge followed by more than $ 13 trillion in capital. With each adjustment moving billions of dollars around the world, inclusion is a game-changer for boards of directors across America.

“The S&P probably exercised significant discretion in deciding which companies to add to the index,” wrote authors Kun Li and Xin Liu of ANU and Shang-Jin Wei of Columbia in the study. “The data models suggest that discretion is often exercised in a way that encourages companies to purchase paid services from the S&P.”

In a statement, S&P Global called the discussion paper flawed.

“S&P Dow Jones Indices and S&P Global Ratings are separate companies with policies and procedures to ensure they are operated independently of each other,” he said. “Our index governance separates analytical and trading activities to protect the integrity of our indices. For 64 years, the S&P 500 has provided an independent, transparent and objective benchmark for the US large-cap equity market.


At first glance, there is a simple explanation for the study results: a growing company applies for a credit rating in order to finance its expansion efforts – a move that can help the company get into the index. on its own merits.

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 of its rival Moody’s Investors Service, which is not an index provider. major. This is especially the case when recent additions benefit from sharp price increases, making inclusion ever more attractive.

The index provider uses a high degree of discretion in deciding which companies to enter, the researchers said. They found that the official S&P 500 criteria explained only about 62% of gauge members during the time period studied and only 3% of additions. These percentages are well below those of the London Stock Exchange’s Russell 1000 index, they said.

“S&P appears to be deviating from its published criteria in its decisions to add companies to its index much more than Russell,” the newspaper said.

Reference behemoth

All of this adds to the debate over the extraordinary power wielded by index providers in modern markets. About $ 5.4 trillion in assets directly follow the S&P 500, while an additional $ 8 trillion uses it as a benchmark, according to S&P estimates.

S&P Global’s own research has argued that the impact on stock prices of companies joining the S&P 500 – the so-called index effect – has diminished in recent years. In other words, there is less incentive for a business to try to gain admission to the gauge.

Meanwhile, a discretionary element of the inclusion of the S&P 500 is openly recognized by the benchmark provider. Company size is a major factor, as are liquidity and profitability, with the final decision made by an index committee. Tesla Inc. collapsed when it was removed from the benchmark in a quarterly replenishment, even though it appeared to meet the requirements. Three months later, he finally succeeded.

The index committee aims to minimize turnover and take into account sector representation, according to the methodology of the firm. Changes in the composition of the index are made as needed and “changes in response to corporate actions and market developments can be made at any time,” he said.

Read more: Active management pays off for S&P 500 index gatekeepers

In the document, Li, Liu and Wei said it was not clear if and how executives and employees from other parts of the company interact with the committee.

“For the moment, the existing literature has still not studied the objectivity of the composition of the index and the possible conflict of interest in the decisions to join the most followed stock market index”, have- they wrote.

This is a sensitive topic for rating companies, which have been criticized after the global financial crisis by critics who have claimed that they give risky debt securities higher ratings than they deserve to maintain good. relationships with private issuers who paid them.

As recently as 2020, another company, Morningstar Credit Ratings LLC, agreed to pay $ 3.5 million to settle a conflict of interest issue with the Securities and Exchange Commission. The company settled without admitting wrongdoing.

As part of its governance framework, S&P Global establishes “a clear separation of distinct functions and duties across the organization,” according to its website. “This ensures effective mitigation and management of conflicts of interest,” he says.

Not worthy

Researchers see potential economic downsides for those following the S&P 500 if less eligible companies are added to the gauge. Companies that beat their most qualified peers to enter the index do less well in subsequent years, according to the newspaper.

Without citing specific examples, he said these companies saw on average a 14.6% drop in profitability and a 37% drop in return on assets in the four years after joining compared to similar stocks. which remain excluded.

They also invest around 13% more in the two years after joining, echoing concerns that entering an index loosens the chains of shareholders on what can prove to be costly corporate decisions.

“Their relative advantage in terms of cost of capital and investment suggests a possible misallocation of resources in the economy induced by S & P’s discretion in its index membership decisions,” the newspaper said.

The US-based NBER is a network of nonprofit economists that regularly releases working papers to foster debate.

Li and Liu are finance professors at ANU. Wei is a professor of finance and economics at Columbia and was the chief economist of the Asian Development Bank.

(Updates with more context, including the Tesla miss hint.)

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