We all have a fascination with finding the person “behind the curtain,” the Great Oz who exercises ultimate control. In reality, wizards are few and far between. With reams of data now demonstrating that exchange traded funds (ETFs) and index mutual funds don’t actually fuel the markets, pundits have started to look for a new magician, a single force that inflates asset bubbles and then catastrophically explodes them.
Some have set their sights on index providers, suggesting that the decisions to include and exclude companies influence their stock performance. In practice, what drives prices higher and lower aren’t the authors of index inclusion rules, but the market participants themselves–those actually doing the buying and selling.
Can’t buy happiness
The argument is based on a mis-perception of how indexes work. Index providers don’t generally pick and choose the specific companies in an index. Rather, they create a set of inclusion criteria. Company characteristics, such as market capitalization, are the most common. For example, the S&P 500 Index consists of the roughly 500 U.S. companies whose stocks have the greatest total market value. (Apple topped the list at about $920 billion in mid-May.) Other inclusion criteria combine different “ingredients,” such as industry or styles like value and growth. Criteria for overseas markets may not pertain to specific companies at all, but to market quality and accessibility conditions, such as the ability of offshore investors to transact in the local equity market or to convert local currencies to dollars. Other characteristics are also incorporated, like minimum available shares (float), a minimum closing price (e.g. one dollar) and minimum voting rights.
In short, the indexes are trying to capture correctly a truly investable universe of stocks – meaning that an investor should be able to deploy a material amount of capital against the index and realize close to its published return. That would disqualify the Gross Happiness Index of Bhutan and the International Roughness Index. Or, closer to home, indexes tracking economic “surprise,” manufacturing levels or home prices. By some counts, there are about 1,000 investable indexes globally, each with distinct published guidelines.
If the stock fits…
If index providers set out the inclusion criteria, it’s the market that determines the companies and their relative weights in an index. For example, a typical large-cap blend index would have inclusion criteria based on a threshold for market capitalization, such as $10 billion; it would also specify things like float, liquidity and so on.
With those guideposts selected, the index providers’ work is generally done. So, how do companies get in the large-cap blend index? First and foremost, a company needs to hit the market capitalization threshold of $10 billion or more. Market capitalization equals the number of a company’s shares outstanding multiplied by the market price per share. In other words, it’s the market price determined by stock pickers that will render a company large cap or not. The migration of companies up and down the capitalization stack–from small to mid to large-cap–is entirely decided by the active stock pickers in the market. Indeed, it can be a bittersweet moment for small-cap managers when a company exits small-cap indexes. But the reason it exited is that the market has bid the stock higher, not because the index provider unilaterally chose to make a small-cap stock a large-cap stock.
In the Wizard of Oz, Dorothy travels a long way to discover things she knew all along. When she finally reaches the Emerald City, she also discovers that the great and powerful Oz is just a person. I’d suggest we avoid a lengthy journey because it won’t be as much fun as Dorothy’s, and we already know the answer. We know it’s the stock market that decides the price of stocks, not the authors of indexes. They may set out the playing field, but they don’t pick winners and losers. Watch this video to learn more about how indexes are built.