The role of discretion in S&P 500 membership decisions encourages prospective entrants to engage in conflicts of interests to gain favour, according to research conducted by the National Bureau of Economic Research (NBER).

Findings of the report, titled Is Stock Index membership For Sale?, “consistently” suggested a positive correlation between a company purchasing services – such as ratings – from benchmark provider S&P Global and having a higher chance of entering the renowned S&P 500 index.

NBER identified a “positive and significant” link between firms large enough to be considered for index inclusion and the likelihood of purchasing rating services from S&P Global.

Similarly, in quarterly periods where mergers between existing S&P 500 members occur, non-index firms were more likely to buy S&P ratings, implying there is a stronger incentive to buy the provider’s products when an index vacancy exists.

This is particularly noticeable in the firms ranked from 300 to 700 in US market capitalisation. In this stratum, firms on either side of the inclusion threshold for market cap have the strongest incentive to compete for membership, NBER said, and many appear to think purchasing S&P ratings increases their odds of being added to the S&P 500.

Furthermore, during periods when S&P 500 entry may lead to high cumulative abnormal returns, firms ranked between 301 and 700 display an “especially strong” incentive to buy S&P ratings while firms ranked below 1,000 for size do not buy more ratings when index openings appear.

Similarly, companies in the top 300 for market cap did not tend to buy more ratings during these periods, likely because they feel their index membership is not in question.

NBER then presented a case study from July 2002 when S&P announced a rule change that excluded all companies not headquartered in the US from its flagship index.

This not only saw seven foreign-domiciled firms removed from the benchmark but S&P rating purchases by foreign firms reduce by 72.2%. Significantly, purchases of Moody’s ratings – the second-largest ratings provider after S&P Global – did not change at all following the rule change.

“The contrast between foreign firms’ purchase of S&P ratings versus Moody’s ratings speaks volumes,” the report said. “The patterns clearly suggest that foreign firms bought S&P ratings partly because they believed that such purchases could “buy” an improved chance to get into the S&P 500 index.”

Far from this exclusively being the result of opportunistic company behaviour, NBER stressed the potential for conflicts of interest are baked into the S&P 500 membership decision-making process.

The research found 38% of index membership and a staggering 97% of the index additions involve discretionary considerations that are not predicted by the published rules.

Strikingly, for comparison, published rules for the Russell 1000 can explain around 93% of index membership and 75% of index additions between 1996 and 2006, NBER said.  

The report added: “Instead, we find that, on average, about 33% of actual additions in a year violated at least one of the published selection criteria. Among the criteria, financial viability and public float were most likely to be violated.”

Likewise, between 118 and 144 firms a year were not added to the index despite meeting all of the necessary selection criteria.

“We conclude that S&P Global often uses discretions outside the published criteria when deciding which firms to add to the S&P 500 index,” the research continued. “In short, S&P appears to deviate from its published criteria in its decisions on adding firms to its index much more than FTSE Russell does.”

However, the discretion-based nature of S&P 500 inclusion decisions is common knowledge and a hotly debated part of the benchmark’s methodology. This surfaced again recently as GameStop hit a market cap of $13bn, comfortably above the threshold for inclusion, but S&P Global’s index committee remained doubtful about the firm’s ability to sustain its currently impressive earnings.

The NBER research also cast doubt on the impartiality of this committee, which it noted is made of anonymous S&P Dow Jones Indices employees, with the nature of their interactions with other employees and executives in the company remaining unclear.

“In principle, reputational concerns can deter S&P Global from engaging in activities that present a conflict of interest,” the report said. “However, rating agencies in general, and S&P Global in particular, are not free from conflicts of interest in other areas.”

Referring to a paper by professors Matthias Efing and Harald Hau from 2014, NBER said there was evidence rating agencies, including S&P Global, “systematically” give more favourable ratings on structured debt securities to firms that maintain more expansive business ties.

In sum, the risk of reputational damage may not be a strong enough deterrent for avoiding conflicts of interests, including pay-to-play dynamics in index membership.

Responding to NBER’s findings, an S&P Global statement said the findings were flawed and that S&P Dow Jones Indices and S&P Global operate entirely independently of one another. 

Once peer-reviewed, NBER’s investigation could prove significant for the most popular US equity benchmark and passive investing as a whole. Between 2000 and 2019, the number of funds tracking the S&P 500 doubled, while their assets under management (AUM) collectively tripled to $5.5bn, NBER found, with ETFs’ share of this number only rising in the past two years.