The S&P 500’s pitch is simple. Own it and get exposure to the biggest of the big among US firms. Lately, it’s gotten harder to maintain that point of distinction.
Chalk it up to the lopsided nature of this year’s equity advance, which has pushed megacap technology makers ever higher while punishing practically everything else. With almost 250 companies in the S&P 500 nursing losses in 2023, roughly one in five fails to meet the $14.5 billion size threshold set for new members.
That’s about twice as many as normal, according to Bloomberg Intelligence strategists Wendy Soong and Gina Martin Adams, who studied quarterly data going back to 2008.
One is S&P 500 cellar dweller Sealed Air Corp., which after falling 31% this year has a market value of $5 billion, less than 225 firms in the S&P Midcap 400. Now 35 companies in the mid-cap gauge are larger than the smallest 50 members of the S&P 500.
It’s a lesser noticed consequence of the lopsided rally that propelled a handful of artificial intelligence super stocks light years past the rest. At the other end of the size spectrum, companies left behind by the rally have shrunk to the point where they’ve become hard to tell apart from members of mid- and even small-cap indexes.
Besides creating quirks at the border, the blurred lines are a potential headache for quant investors who use size an ingredient in factor strategies. S&P Global, the benchmark’s administrator, has the capacity to redress the distortions but is likely disinclined to do so in a timely fashion. It has traditionally balked at big reshufflings, and has in the past waited for markets themselves to iron out issues when they’ve cropped up.
“If an investor is trying to thoughtfully assemble a collection of funds because they’re trying to target a certain return or volatility goal, it becomes more difficult if they don’t have a certain degree of clarity around exactly what’s in their portfolio,” said Wes Crill, senior investment director at Dimensional Fund Advisors. “Let’s say you were trying to combine the S&P 500 with a small-cap focused strategy. You could have much more overlap between those two than you originally planned.”
The S&P 500 still dwarfs the S&P 400 in total size, with a weighted average market-capitalization of $80 billion among members, versus the mid-cap’s $6 billion. That’s the number active managers focus on when grading their portfolio against a benchmark, and won’t change if the smallest companies at the bottom of the index are shuffled in or out, according to Steven Desanctis, a small-and-mid-cap strategist at Jefferies.
“Their weights are going to be small, their market caps are going to be small, it’s not going to change the weighted average market-cap a whole lot,” he said. “But for passive folks, more turnover is a concern.”
The index asymmetry is unlikely to spark emergency action on the part of its overseers, who tend to consider rashness in switching members a bigger sin. In a heavily traded market, distortions are often temporary and self-correcting, the thinking goes. That restraint has helped the index avoid large-scale turnover during market routs, where a handful of companies drop below index inclusion levels, only to quickly bounce back weeks later.
A representative for S&P Global declined to comment, instead referring Bloomberg News to the firm’s index methodology. The latter says “turnover in index membership should be avoided when possible.” An index constituent that appears to temporarily violate criteria is not deleted “unless ongoing conditions warrant an index change,” the company said.
Linger On
Unlike other index providers, S&P Global doesn’t have market cap requirements for continued inclusion in the S&P 500. That means that stocks can linger in the index, even if they fall below the market-cap threshold.
The index provider also doesn’t have a so-called “reconstitution,” or annual day when companies are added and deleted. While S&P Global rebalances the weights of companies each quarter, it typically leaves additions and deletions for when there’s new M&A activity. Unfortunately for new companies waiting to get into the index, the years-long drought in M&A has left the S&P 500 at its most stagnant since 2011, according to Bloomberg Intelligence.
“It’s a challenge that the S&P has always grappled with because of the fact that they don’t actively reconstitute,” said Melissa Roberts, head of quantitative research at KBW. “For an index performer, that becomes a challenge, because then are you really capturing the largest companies?,” Roberts said.
Roberts estimates there are at least 29 US-listed companies that currently meet S&P 500’s index inclusion criteria, which includes market capitalization and several other factors. More companies have become eligible after S&P Global changed a 2017 rule that barred companies with multiple share classes from joining in April.
“If you’re a portfolio manager, you want the most accurate benchmark to reflect your performance, but if you’re a passive fund manager, you want less turnover because every time the index has turnover, there’s fees,” said Roberts.
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