The stocks in the index most widely used by the financial industry are determined by a combination of general guidelines and the human judgment of a nine-person committee. Companies that outsiders think ought to be included sometimes don't have a chance; others outsiders give up on get included when they least expect it. There are good reasons for the Committee's decisions, and its chairman discusses them here.
The S&P 500 is the most widely used and one of the most widely recognized equity indexes in the United States and the world. While the Dow Jones Industrials, a price-weighted average of 30 large stocks, is more often quoted in the popular press, the S&P 500 is the benchmark most used by investment professionals. Currently, over $750 billion is managed by using the S&P500.
The S&P 500, like the Dow, is managed by a committee rather than determined by a formula or set of rules. Because the Dow covers only 30 stocks, it has relatively few changes and can easily go for a year or longer with none. The S&P 500 is more dynamic. In 1998 there were 48 changes and in the first three quarters of 1999 there were 30. Most of these changes stem from mergers or acquisitions involving companies in the index. Because of this activity, the S&P500 is the best example of how and why committee-managed indexes work and work better than rigid rule-based averages. Given the amount of money tied to the S&P500 and its wide use as a benchmark, it is only natural that the actions of the S&P 500 Index Committee have become an item of interest for investors and the financial press.
This article begins with the goals and objectives for the S&P 500 and other Standard & Poor's domestic US indexes. Then we turn to how these are implemented by the Committee and the guidelines used to guide company selection: The financial markets are always changing and evolving and the index must change as well. In recent years the Index Committee has considered questions about real estate investment trusts, tracking stock, and foreign companies. How these are resolved are often of interest to investors. These issues are important reasons why committee-managed indexes provide better benchmarks and better investments than rule-based mechanical indexes.
GOALS AND OBJECTIVES
The S&P 500 is designed to be a fair benchmark, an investment that reflects leading companies in leading industries in the US stock market and the economy. 'Fair benchmark' means that an investment manager can achieve the same investment results as the index if he or she tracks the index and its changes. Abenchmark that no one can ever match because of illiquid stocks or poor information is not a valid performance measure. With the S&P500, there are numerous index funds -some managing tens of billions of dollars and others managing more modest sums - which match (or exceed) the theoretical performance calculated by Standard & Poor's. The list of index funds includes both publicly available mutual funds and institutional funds. Abenchmark doesn't have to be, nor should be, easy to beat. But a fair benchmark is one that a manager can mimic exactly if he chooses.
There are two aspects to maintaining an index that is a fair benchmark. The first is the selection of stocks to be added to or deleted from the index and the related mechanism of index management. The second, and equally important, is the transparency of the overall process - providing information in a timely manner and in sufficient detail so that a money manager has all the information he or she needs to understand, adapt and use the index.
COMMITTEES VS. RULES
Some indexes, such as the Russell 1000 and 2000, are based on a set of mechanical rules with little if any human intervention. If an index is little more than a list of stocks, the rules approach may suffice. However, if the index is going to be both an investment benchmark and an investment vehicle, the rules-only approach will probably not be adequate and certainly won't keep up with changes in the market. The advantage of a Committee that follows and responds to developments in the stock market and the economy is an index that will stay up to date. Standard & Poor's does not use an index committee to avoid rules and guidelines. In fact, the Committee not only uses guidelines but also publishes the guidelines (see box nearby) and explains how they are applied to specific index actions. Standard & Poor's uses a committee because we feel it is not possible to develop rules that will deal with any and all market events So, rather than have immutable rules that must be revised all the time to handle unforeseen events, the Index Committee manages the index as the markets evolve.
GUIDELINES FOR STOCK SELECTION
Standard & Poor's has established guidelines for selecting companies for the index. (These guidelines, together with other index information, are available on an open web site, www.spglobal.com.) These represent a starting point for the Index Committee - because the markets are always changing it is not possible to write guidelines that anticipate every future question or issue. At the same time, guidelines that are too general would be useless for either the Index Committee or the investing public.
Standard & Poor's sees the '500' as leading companies in leading industries. Leading companies are usually large companies and the S&P 500 is an index of large-capitalization companies. However, it is not the 500 largest companies by any measure, nor is size the only measure that matters in company selection. In terms of size, a company added to the S&P500 is usually $3-4 billion or more in market capitalization at the time of addition. Stocks rise and fall, however, and there are some companies smaller than this in the index.
Adding a company is not an investment judgement or recommendation. Standard & Poor's does look at a company's financial condition when considering it as an index candidate. A company should be a viable going concern, but does not have to be a hot stock or some analyst's best pick. In particular, Standard & Poor's equity analysts have no role in selecting stocks for the index.
An important aspect of a fair index is that investors be able to buy the stocks in the index in the correct proportions. With the growth of index funds and rising interest in the 'index effect' - stocks rising when they are added to the S&P500 -Standard & Poor's is concerned with how easy it is for investors to buy stocks as they are added to the index. The question is whether the available float and trading activity will allow investors and index fund managers to buy the stock without creating undue volatility. A stock's liquidity - the ratio of its trading volume to its shares outstanding - is also considered.
For example, in 1998 Berkshire Hathaway acquired General Re. At the time of the acquisition, General Re was in the S&P500 and there was widespread discussion over whether Berkshire Hathaway would be added to the S&P500. After all, ran the obvious argument, if General Re belonged in the 500 on its own, surely a combination including not only it but also another insurance concerns and a variety of other businesses belongs there too. With an index like the Russell inclusion might indeed have been almost automatic. However, Berkshire Hathaway's class Ashares, recently trading at about $55,000, are among the highest priced stocks traded anywhere. Standard & Poor's reviewed both classes of Berkshire Stock (class B shares are 1/30th of the class A shares) and felt that liquidity would present difficulties for investors and fund managers. T
he concern was not only about what might happen at the initial addition of Berkshire to the S&P 500. There was also the problem of trading associated with subsequent index changes involving other companies. When a large stock with a capitalization of several billion dollars is removed from the index and is replaced by a much smaller stock, index funds must redeploy large amounts of cash - from the proceeds of selling the larger stock's position - across the rest of the stocks in the index, as they adjust their portfolios to match changes in the index. If the index were to include stocks of limited liquidity, one might experience difficulties in trading these stocks during some routine index changes.
Another factor that may be related to liquidity is a stock's float or how much of the outstanding stock is closely held. Standard & Poor's will examine data on float in reviewing a stock for an index; a company with a substantial portion of its stock closely held may not be added to the index.
Large scale cross-ownership is uncommon among US companies and is generally not an issue for companies in the S&P 500. Standard & Poor's does not adjust for cross-ownership in its US indexes; however, in extreme cases restricted float could lead to eliminating a stock from consideration if due to significant cross ownership.
The S&P 500 should reflect the makeup of the stock market and the economy. Theoretically, reflecting the economy is the ultimate goal, but this is not achievable. There are some kinds of legitimate economic activity that are not reflected in the stock market. For example, many professional service companies such as law firms or accounting firms are not represented by any publicly traded or investor-owned corporations and are not on the stock exchange. In other industries, only some portions are represented in the stock market.
This does change over time, and these changes will be reflected in both the markets and the index as they occur. For example, a large portion of the insurance industry currently consists of mutual insurance companies owned by their policy holders rather than investors. This is likely to change in the next few years as many of these mutuals convert to stock ownership. When this happens the larger ones will be prime candidates for inclusion on the S&P 500.
Asomewhat different picture is seen in health care. Two or three decades ago, relatively few physicians practiced as part of publicly traded companies. Today this is shifting, and some health maintenance companies are traded in the markets. Here, too, some of the larger companies that emerge may become candidates. In some cases an important industry may not have very many large companies, so its representation in the stock market is different from its representation in the overall economy. Homebuilding and real estate development can be cited as examples.
Where economic activity is represented by publicly held companies, it will be reflected in Standard & Poor's indexes. Standard & Poor's classifies each publicly traded company into an economic sector, industry group, industry and sub-industry. These classifications are used to compare the composition of the index to the composition of the overall market and the market, broken into different market capitalization ranges. It is virtually impossible to have the proportions in different economic sectors in the index exactly match the overall market proportions. However, the index does come close over periods of time. The Index Committee monitors shifts in the composition of the index and the market, and often moves to bring the index closer to the market.
The S&P 500 is meant to cover US companies only. In recent years questions of what is a US company have occasioned a good deal of discussion within, and about, the Standard & Poor's Index Committee. The index does currently include a few non-US companies, most notably Royal Dutch Shell and Unilever. They were added many years ago and were grandfathered into today's index. They would not be added today, regardless of whether a US exchange is considered the principal exchange for its shares, or reports the preponderance of trading in them.
One might think that a company's nationality would be simple and obvious. Unfortunately this is not always the case. Among the issues considered are where a company is headquartered; where it maintains executive offices; where it is registered or incorporated; where it pays taxes; how it reports financial results - including both currencies and accounting practices; how its management is organized; where most of its employees are located; and where the revenues and profits are generated. If only the revenues and profits were considered some American companies might not be included. No one is likely to argue that Coca-Cola is not an American company. Yet, it generates well over 60% of its revenues and earnings from outside the United States. Coca-Cola is both an American company and a member of the S&P500.
One recent case that occasioned a lot of discussion was the merger of the Chrysler Corporation and Daimler-Benz to form DaimlerChrysler. Standard & Poor's concluded that the merged corporation is a German company and removed Chrysler from the S&P500 at the time of the merger, even though a large proportion of its combined revenues was contributed by Chrysler. DaimlerChrysler's structure follows the German model with a supervisory board and a management board. DaimlerChrysler is registered in Germany, and reports according to European and German accounting in Euros. The company currently has executive offices in both the United States and Germany, but most large investment organizations that follow the company analytically consider it to be a German company. Since the merger, a large majority of equity indexes and index vendors have taken the same position as Standard & Poor's.
More recently, Global Crossing acquired Frontier. Frontier was a member of the S&P 500 and a US company. Global Crossing is registered for tax purposes in Bermuda with executive offices in the United States. Other than the Bermuda tax registration there is little question about nationality - US operations, US management structure, US accounting, and reporting in US dollars. There are precedents: a number of longstanding S&P 500 companies with tax registrations outside the United States that are considered American companies. These include Schlumberger in the Netherlands Antilles and McDermott and Carnival Cruise Lines in Panama. We had little trouble adding Global Crossing to the S&P500 when it concluded its acquisition of Frontier.
While most index changes result from mergers or acquisitions of companies in the index, there are a few occasions when the Index Committee will initiate changes. One case is when a company is removed for what we call lack of representation. Unfortunately, not all companies grow as fast as the overall stock market and some may fall way below their former peers. From time to time, when a company is far too small compared to other companies, when trading in its stock becomes very thin, or when the stock price drops to extremely low levels, the company will be removed from the index. A recent example was
Fruit of the Loom. At the time it was selected for removal its share price was 3.3125, its market capitalization was $238.9 million, and its average daily volume was running at about $7.1 million. There are always a few companies in the index which would not qualify as candidates for addition today. At times there are company additions. One of the more notable ones in recent years was America Online (AOL). Because of the consumer oriented nature of its business and the general hype of the Internet, AOLis a widely known and much discussed company. However, for a number of years its stock market fortunes rose and fell rapidly. Beginning in mid-1997, the Index Committee began to follow AOL closely. During much of 1998 the stock's possible entry into the S&P 500 was a matter of wide speculation. Not wanting to encourage the speculation, Standard & Poor's watched the discussions from the sidelines. We do not want to move markets with our decisions if that is avoidable. That is not one of our goals as an index provider; in fact, one of our goals is to avoid unsettling markets. Nor do the exchanges want to encourage speculation that might lead to significant price swings based on our Committee's decisions.
By late in the year, the discussions began to fade as many market commentators decided that Standard & Poor's would never add AOLto the S&P500. With the hype fading, Standard & Poor's announced the stock's addition to the index as a replacement for Venator (formerly Woolworth).
THE COMMITTEE PROCESS
The Standard & Poor's Index Committee has nine members, all Standard & Poor's employees. All members are drawn from the Investment Services group at Standard & Poor's and all have various job responsibilities related to the indexes and the equity markets. The Committee includes two analysts monitoring the companies in the index who provide necessary support and index-management expertise within the Committee.
In addition, the Index Committee draws on the broad resources of Standard & Poor's many areas. These include the information and databases that support Standard & Poor's Stock Reports, AdvisorInsight, MarketScope and Compustat services, the data on the indexes themselves compiled and published by Standard & Poor's Index Services department, and a large analytical team of over 50 professionals covering US equities.
While the Index Committee meets once a month, index management - determining the exact day a merging company should leave the index, for example - is a continuous operation day in and day out. At each meeting, the Committee reviews pending corporate actions and decides what changes will be required in one or another of Standard & Poor's indexes. The Committee maintains lists of candidate companies for the S&P500, the S&PMidCap 400, and the S&P SmallCap 600. There are normally five to 15 stocks for each index, approved by the Committee and ready for inclusion at any time, usually from a wide variety of industries. The two analysts on the Committee manage the index on a day-to-day basis and implement changes directed by the Index Committee. They are supported by the Index Services Department where various databases are maintained. From time to time, market events may overtake planned index changes, such as when a candidate company about to be announced as an index addition becomes the target of a takeover attempt. Standard & Poor's has procedures in place, including conference calls if necessary, to assure that Index actions can be revised or changed on very short notice by the Index Committee with essential discussion and agreement, and without compromising confidentiality.
Some investors and journalists seem to have images of pitched debates over issues that will move the stock market. As disappointing as the truth might seem, this is rarely, if ever, the case in the Index Committee. Most decisions have very limited, if any, market impact. Relatively few issues are hotly debated. The process is based on developing a consensus, not scoring debating points. Discussions where there is initial disagreement will continue until everyone has had an opportunity to present his or her view and a consensus has emerged. While most of the issues mentioned in this article were discussed in the Committee, none were the subject of any pitched debates. Moreover, we make sure that none of the Committee members disagrees with the ultimate decisions.
Changes in the S&P 500 and other Standard & Poor's indexes do sometimes move stock prices. Because of this, Standard & Poor's considers all index changes and announcements to be market sensitive. Announcements of changes are made at 5:15 PM New York time, which is when the composite tape officially closes trading attributed to that day. Index changes are distributed to the major news services at that time. Announcements are also posted on Standard & Poor's Index Services Web site, www.spglobal.com. All members of the Index Committee plus other Standard & Poor's staff who work on index matters and have access to index information are subject to certain restrictions on their personal securities investments and trades.
Transparency is almost the opposite of confidentiality. Standard & Poor's general index process and guidelines, as discussed here, are not confidential and are open to the investing public. Several times a month Standard & Poor's is contacted by companies asking how the indexes are run and how companies are selected. All these inquiries are answered and responded to. It is not possible to meet with all the companies making inquiries - and many of them obviously do not qualify for any current Standard & Poor's index. However, the Index Committee does meet with companies currently in the index to answer questions or to help the Index Committee understand pending transactions involving companies in the Index. The Index Committee also meets with representatives of major index users or other interested parties including securities exchanges, money managers, mutual fund companies, and other groups.
We do not, however, encourage extended conversations with those who want to know what they have to do to get a company into the S&P 500. For them, our answer is simple: Just build it into one of the leading US companies in a significant US industry, with adequate market liquidity, and the Index Committee will take care of the rest in due course.