The index committee at S&P Dow Jones Indices (SPDJI) has once again fallen under scrutiny bringing into question the long-term viability of an opaque group that has the final say on whether a company is allowed to join flagship indices such as the S&P 500.
Last week, a paper from the National Bureau of Economic Research (NBER) found a positive correlation between acompany purchasing ratingsfrom S&P Global and having a higher chance of entering the S&P 500.
“We show that firms’ purchases of S&P Global ratings appear to improve their chance of entering the index (but purchases of Moody’s ratings do not),” the research said. “Furthermore, firms tend to purchase more S&P Global ratings when there are openings in the index membership.”
This report simply adds fuel to what is already a brightly burning fire. Last year, a member of SPDJI’s index committee was charged with being part of an insider trading scheme where he tipped an associate when companies would be added and removed from the provider’s range of indices.
“I was surprised when they did not make changes when one of the committee members was charged for tipping off [an associate],” Gareth Parker, chairman and chief indexing officer at Moorgate Benchmarks, said.
“This will add additional impetus.”
Responding to the research, SPDJI said in a statement: “This non-peer-reviewed paper is flawed and contains a number of misleading and inaccurate statements about the S&P 500, its methodology and eligibility rules and the impact of index inclusion. SPDJI and S&P Global Ratings are separate businesses with policies and procedures to ensure they are operated independently of one another. Our index governance segregates analytical and commercial activities to protect the integrity of our indices.”
Where SPDJI’s index committee differs from other firms is it has an active discretionary decision in the addition and removal of companies within its indices. This is in contrast to committees at other index providers which simply discuss whether the rules of a particular strategy needs adjusting.
“Index committees are very boring. They spend their time reviewing the rules,” Parker continued. “The days of smoke-filled rooms are largely behind us.”
Over the years, SPDJI has been very positive about the index committee’s ability to select stocks. The process was shaped by the firm’s former index committee chairman David Blitzer who argued it allowed the S&P 500 to more effectively represent the US large-cap equity market.
In a 2014 blog post, Blitzer said: “The committee is not trying to pick stocks to beat the market. Rather, we use guidelines for stock selection – size, liquidity, minimum float, profitability and balance with respect to the market – to assure that the index is an accurate picture of the stock market.”
However, the use of the committee brings human error into the fold. The underperformance of active managers is well documented and this is not too dissimilar from the committee failing to include stocks such as Tesla until after the electric vehicle manufacturer had rallied significantly.
As academic Bernard Sharfman and Stone X’s Vincent Deluard said in a paper earlier this year: “It is hard to understand why the world’s leading electric car maker and the largest US automaker by market value was left out of the S&P 500 for so long. Whatever the reason, if the committee would have included Tesla several years before it did, the returns of funds that track the S&P 500 would have significantly increased.”
A key advantage SPDJI indices have over others is traders are unable to front-run upcoming changes due to the discretionary element involved but as Parker said this is a small “price to pay” for employing a transparent, rules-based approach.