Deep look at the S&P 500 index the world most important index

To gauge U.S. stock market performance, the S&P 500 is the most widely quoted index in America. The Dow Jones is also very widely known but lacks accuracy as a broader stock market performance gauge and has evolved into being more of a sentiment gauge on how people feel.

The S&P 500 consists of the leading 500 companies. This index was created on March 4^th 1957 but it wasn’t until about 20 years later in 1976 when John Bogle created the first index tracking the S&P 500 making it possible to invest in the S&P 500 sparking the titanic passive investment shift that would follow. Today when many investors talk about passive investing, they often reference the S&P 500 consciously or subconsciously. This index dominates many other smaller indexes created with approximately 4.6 trillion dollars indexed or mirrored to match the performance of the S&P 500 before fund fees. Active management is also largely benchmarked by the yardstick of this iconic index. Today there are over 11.2 trillion dollars benchmarked to the S&P 500 index. The S&P 500 also garners fame and notoriety overseas with many investors in foreign countries familiar with the index. The index is so powerful that a large drawdown in the S&P is a telling sign that global economies are headed in a bad direction.

The S&P 500 index is run and controlled by the S&P Dow Jones Indices. The S&P Dow Jones Indices has a set of criteria and guidelines on what constitutes an eligible S&P 500 company that I will go into deeper. The S&P Dow Jones has an index committee that reviews each company for inclusion and exclusion to the index. While the S&P 500 is viewed as the passive gold standard. It is largely an active bet on the S&P Dow Jones picks.

The active portfolio manager of the S&P 500

David Blitzer is the man behind the curtain leading at the Chairman of the S&P Dow Jones Index Committee since 1995 and did not retire until recently in 2019. He has been a leading authority in deciding stocks to include and exclude from the S&P 500 index. The S&P 500 has a set of outlined rules on stock inclusion but has a largely discretionary piece that resembles much more active management than passive management. An extreme example of this active management approach is in the S&P 500 was during the financial crises. AIG was severely under meeting the float requirements when the US Treasury decided to bail out AIG and purchased 90% of the company. Blitzer and the index committee’s decision to not drop AIG from the index during this time was concern it would send markets in a negative direction. Whether the decision was right or wrong shows the heavy active moves the S&P 500 has taken at various points in time. That said let’s take a closer look at some of the guidelines the committee follows on a regular basis.

S&P Guidelines

Domicile rules

To be eligible the U.S. Stocks must meet the following criteria.

1. Files 10-K annual reports.
2. The U.S. portion of fixed assets and revenues constitutes a plurality of the total, but need not exceed 50%. When these factors are in conflict, fixed assets determine plurality. Revenue determines plurality when there is incomplete asset information. Geographic information for revenue and fixed asset allocations are determined by the company as reported in its annual filings.
3. The primary listing must be on an eligible U.S. exchange as described under Exchange Listing below.

If criteria #2 is failed or ambiguous the S&P Dow Jones committee may still consider adding the company to the index. The committee makes an active decision for the final determination of the companies domicile and if it should or shouldn’t be included in the index. Factors the criteria the Index Committee looks at in the final determination are where are the operational headquarters location, ownership information, location of officers, directors, and employees. This discretionary decision may seem simple but could have blurry situations with most large companies having strong international business ties which could make the company in question considered a foreign company excluded from the S&P 500 index. An example is a Chinese incorporated company that is listed on a U.S. Exchange. The S&P index policy rules state these companies will continue to be considered Chinese and excluded. However, if the Chinese company in question is large, traded on a U.S. stock exchange, and many of the products are used in America it is easy to see how confusion could arise in assuming the company may be part of the S&P 500 at first glance.

It’s all about the float

Float is a term that represents how many shares are considered investable. If a publicly-traded company has an executive or family that owns half the shares of the company and never plans to sell them, those shares are not considered investable and excluded from a company’s Float. The Float calculated for the S&P 500 determines the market cap weighting making it a critical input. For example, there could be a large company that should be considered bigger in the S&P 500 but due to having a small float, the stock may not make up much of the index.

Shares held by the following types of shareholders are excluded regardless of whether the particular shareholder intends to exercise any form of control.
Long-term strategic shareholders generally include, but are not limited to:
1. Officers and Directors (O+D) and related individuals whose holdings are publicly disclosed
2. Private Equity, Venture Capital & Special Equity Firms
3. Asset Managers and Insurance Companies with board of director representation
4. Shares held by another Publicly Traded Company
5. Holders of Restricted Shares*
6. Company-sponsored Employee Share Plans/Trusts, Defined Contribution Plans/Savings, and Investment Plans
7. Foundations or Family Trusts associated with the Company
8. Government Entities at all levels except Government Retirement/Pension Funds
9. Sovereign Wealth Funds
10. Any individual person listed as a 5% or greater stakeholder in a company as reported in regulatory filings (a 5% threshold is used as detailed information on holders and their relationship to the company is generally not available for holders below that threshold).
* Restricted shares are generally not included in total shares outstanding except for shares held as part of a lock-up agreement.
Included in the float
The following holders’ shares are generally considered part of public float:
1. Depositary Banks
2. Pension Funds (including Government Pension and Retirement Funds)
3. Mutual Funds, & ETF providers, Investment Funds, and Asset Managers (including Hedge Funds with no board of director representation)
4. Investment Funds of Insurance Companies
5. Independent Foundations not associated with the company

Share classes

It’s very common for large companies to have multiple share classes. The S&P Dow Jones guidelines for picking the share class of a company to include in the S&P 500 is based on liquidity per the committee. The committee prioritizes liquidity over share class voting rights which makes sense due to how much money is invested based on the S&P 500 though it may be better for an investor to have voting rights if there is no premium for the shares. There is supposed to only be one share class included in the S&P 500 but as you will find with the index it’s full of exceptions in 2014 Google released a class C share stock offering. While the S&P rules state to only include one share class Google had both it’s class A shares and class C shares both listed in the S&P 500.

Dividends

On the news and other daily consumable finance content, the S&P 500 is often quoted as a ticker only accounting for its price return and excluding its dividends. The total return index includes dividends and assumes the dividends are reinvested and spread over the index as a whole. The dividends are not reinvested in the same companies the dividends got paid from. As dividend re-investment programs plow dividends back into the stock that paid them if someone bought all S&P 500 companies individually versus an index product like an ETF or mutual funds their risk-return may be quite different due to the possibility of how dividends re-invested may be under two different methods.

The S&P 500 is another tool, in the tool shed

Passive investing has grown massive traction due to extremely low fees, tax efficiency, and simplicity. Passive investing also has plenty of evidence to back up its long-term claims of outperforming many active managers, in particular, active managers benchmarked to the S&P 500. With razor-thin expense ratios investing in the S&P 500 investors, today get a whole committee setting rules and monitoring certain discretionary situations for dropping or adding a stock close to free. It’s almost like having free portfolio management which is a great deal for the investor. However, investors would be wise to stay cautionary that no index is the end all be all, and humans are still making active decisions on these “passive strategies” somewhere in the decision chain. An index fund is an investment tool and when hammering a nail it’s probably not a good idea to try and use a wrench. While we have become fixated on the S&P 500 as the gold standard of benchmarking and indexes S&P Dow Jones themselves have created numerous indices that are variations of the S&P 500 for those same reasons. Some of these include sector cap-weighted variations so no sector like tech can dominate the index. Subsets of the index S&P 100 or Top 50 since these top companies make up the majority of the weight in the index. The S&P Dow Jones has also created an equally weighted version of the S&P 500 after the tech blow up in 2000 when a handful of companies dominated the index similar to now. The S&P 500 by design has a momentum component built into it as the big grow bigger the index performs well but that can also work in the opposite direction in a market collapse. While I expect the S&P 500 to only continue to grow in influence as passive investing is continually on the rise, the S&P 500 is just another hammer that can solve many problems but it shouldn’t be the only tool you use to solve every problem.

Resources:

https://www.investopedia.com/terms/j/john_bogle.asp#:~:text=In%201976%
2C%20Bogle%20introduced%20the,a%20commission%20on%20investment%20purchases.

https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview

https://www.reuters.com/article/us-usa-stocks-sp-timeline-idUSBRE9450WL20130506

https://www.indexologyblog.com/2013/07/09/inside-the-sp-500-selecting-stocks/

https://www.indexologyblog.com/2013/12/06/inside-the-sp-50 0-multiple-share-classes-and-voting/