Stocktake: Is stock index membership for sale?

Can companies buy their way into the S&P 500 index? It seems an extraordinary question about the world’s most widely-followed index. However, a recent working paper, bluntly titled Is Stock Index Membership For Sale?, suggests grounds for concern.

Investors might assume membership is governed by a strict set of rules regarding market capitalisation, free float, and so on. These are factors, but index providers also have some discretion.

S&P 500 membership decisions have a “non-trivial amount of discretion”, the paper says, more than other indices like the Russell 1000.

The study found that when companies buy credit ratings from S&P, it seemingly improves their chances of entering the index, whereas buying ratings from rival rating agency Moody’s do not.

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Companies, especially those ranked from 300 to 700 in market capitalisation, typically buy more S&P ratings (but not Moody’s ratings) when there are openings in the index membership.

Foreign firms

Additionally, the study notes that a rule change in 2002 resulted in foreign firms being excluded from the index. After the rule’s introduction, there was a noticeable reduction in S&P rating purchases by large foreign firms.

This can have economic consequences: discretionary index additions subsequently fare worse in terms of profitability relative to other large companies that are excluded for discretionary reasons.

The data suggests S&P’s discretion is “often exercised in a way that encourages firms to buy fee-based services from the S&P”, say the authors. S&P has denied the claims.