Academics cast harsh light on composition of S&P index


For some listed companies, gaining membership of a major stock index is akin to joining an exclusive club, recognition for years of hard work. But a trio of academics this week came up with a hypothesis on another way to get in: a short-cut that involves hard cash.

A working paper published by the National Bureau of Economic Research argued that companies buying credit ratings from S&P Global’s ratings business had a statistically significant impact on the likelihood of being added to the S&P 500, the benchmark index of US blue-chips run by another subsidiary, S&P Dow Jones Indices.

S&P has firmly denied the findings of the paper, titled “Is Stock Index Membership for Sale?”, calling it “flawed”. It said its two units “are separate businesses with policies and procedures to ensure they are operated independently of one another”.

The report has nonetheless drawn attention to S&P’s dual roles. As Shang-Jin Wei, a professor of finance at Columbia University and one of the NBER paper’s co-authors said, “the objectivity of a major market index is extremely important”.

The credit rating agency is hugely influential. It was widely criticised for its role in the 2008 financial crisis, giving high ratings to risky pools of specialised loans, but for more than a decade since then, it has remained one of the top ratings firms helping debt investors judge companies’ creditworthiness.

The S&P 500 is one of the world’s most-followed and prestigious indices, tracing its history back to the soaring US stock market of the 1920s. Around $13.5tn of assets directly track or are benchmarked against the S&P 500, making the index compiler a traffic cop determining the flow of investors’ money.

S&P is aware of the risks that anything should shake investors’ faith in the equities benchmark.

“For me, I think it’s a real opportunity for the [S&P 500] committee to have some more rules that make it more transparent like the other indices. That would help them avoid this type of assertion,” said Laurence Black, a former index designer who now runs The Index Standard, a specialist consultancy.

S&P Dow Jones separates its analysis and commercial teams, to protect the integrity of its indices. The business is also run as a joint venture between S&P Global and CME Group, the US derivatives exchange, although S&P Global owns a 73 per cent stake.

David Blitzer, who led S&P’s index committee for more than two decades until 2019, said it would have been impossible for ratings purchases to have any bearing on who joins the index.

“When I chaired the index committee, I was prohibited from speaking to anyone in S&P Ratings without legal counsel present . . . even if a company CFO bought more ratings, the index committee would never know,” he said.

The paper argued that many firms “appear to believe that purchasing S&P ratings . . . is helpful to their chance of being added into the index”. The academics analysed rating purchase information from S&P’s own database, alongside data from other providers including Moody’s and the University of Chicago’s Center for Research in Security Prices.

Column chart of Revenue  ($bn) showing Indexes are a growing proportion of S&P's revenue

The academics found that potential candidates to join the S&P 500 increased their purchases of S&P ratings when there was known to be an opening in the index, such as when two existing members agreed a merger. Meanwhile there was a sharp drop in purchases by foreign firms when S&P changed its rules to prevent them from joining the index in 2002. In each instance, there was no similar change in purchases of ratings from S&P’s biggest rival, Moody’s. S&P countered that the paper “contains a number of misleading and inaccurate statements about the S&P 500, its methodology and eligibility rules, and the impact of index inclusion”.

S&P vies with rivals such as MSCI, FTSE Russell and Morningstar to offer investors what they regard as a “truer” reflection of the stock market. It is an industry worth more than $4bn a year, according to Burton Taylor International Consulting, and S&P’s 25 per cent market share puts it marginally ahead of MSCI and FTSE Russell. For S&P Global, the indices business is just 13 per cent of its revenues; credit ratings account for half.

David Blitzer, former chairman of S&P Dow Jones Indices
David Blitzer, former chair of S&P Dow Jones Indices © Jin Lee/Bloomberg

Experts said the S&P 500’s unique approach to choosing its constituents, with an element of discretion, made it particularly vulnerable to suspicion or misunderstandings.

The Index Standard’s Black said the S&P 500 is “a real anomaly compared to other benchmarks” such as the FTSE Russell 1000, which is based almost entirely on market capitalisation.

Although largely treated as a proxy for America’s biggest companies, the S&P 500 does not comprise the 500 biggest stocks in the US market.

Instead, it consists of what S&P Dow Jones calls “leading companies from leading industries”. Generally companies need to have a market capitalisation of at least $13bn and meet minimum standards of profitability and liquidity. Ultimately, membership is at the discretion of a committee of full-time S&P Dow Jones Indices’ staff, which meets monthly. It takes what it calls an “informed approach”, that allows for quick adjustments when a company’s financial status or overall market conditions change, it says.

“It does speak to a problem they have. While they’ve got that level of opacity, there is always going to be that suspicion,” said Gareth Parker, chair of Moorgate Benchmarks, a UK subsidiary of Morningstar.

The NBER paper highlighted the extent of the discretion used by S&P’s index committee. It said around a third of additions between 2015 and 2018 failed to meet at least one of S&P’s published criteria, despite the fact that hundreds of alternative candidates more clearly met the rules. It added that these “discretionary” additions tended to perform worse after joining the index than “rules-based” joiners.

S&P says the fact that it is hard to predict which companies will be added to the index is one of the benefits of the committee system, which helps to prevent hedge funds from trading on expected changes ahead of announcements.

It has also played down the impact on companies of getting into its index, arguing in a recent report that increased liquidity was contributing to a “structural decline” in the additional stock price gains generated after being added to the S&P 500.

Even so, the findings may yet prod US regulators into further action. S&P has repeatedly been criticised over potential conflicts of interest in its ratings business. In 2015 it paid a $1.4bn settlement with the US Department of Justice after being accused of inflating the ratings it gave mortgage derivatives to win business from rivals in the run-up to the 2008 financial crisis. The SEC also accused it of “a series of federal securities law violations” that continued for several years after.

US regulatory agencies do not have the same powers as in the UK or EU to govern benchmarks. Nevertheless they retain some ability to regulate “through the back door”, because they oversee financial products and their prospectuses. Industry practitioners say their scrutiny of index providers has been growing in recent years.

“The SEC have been very focused on the quality and methodology and conflicts of interest. This does give further impetus to a US benchmark regulation,” said Moorgate’s Parker. The SEC declined to comment.

Asked if S&P could do more to shore up confidence in its products by providing more transparency, one senior employee said “we probably do about as much as we can” already.

Blitzer said the paper “will annoy some of my former colleagues” but he was hopeful that discussion of it would “fade away” in short order. If it does not, S&P will have to step up efforts to fight back.

“The S&P 500 lives on its reputation — you and I could build an index of 500 stocks this afternoon, but we wouldn’t have the brand name and reputation and history of the S&P,” said Blitzer.


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