Chairman of S&P Dow Jones Index Committee talks about decisions like adding Facebook to the S&P 500 and how other changes are made.
“Structure Matters,” by Dan Weiskopf, portfolio manager of Access ETF Solutions, examines issues about ETF structure in a series of interviews with ETF portfolio managers, index developers and other people who affect the structure of ETFs. The goal of the series is to highlight the different operating roles that individuals have that make the ETF structure work well for the investor. In this installment, Weiskopf interviews David Blitzer, managing director, chairman of the Index Committee of S&P Dow Jones Indexes.
Dan Weiskopf: As the managing director and chairman of the S&P Dow Jones Index Committee, can you outline what the Index Committee does and how many people are involved?
David Blitzer: We’ll talk about what we internally call the U.S. committee, which is the committee that covers the S&P 500, S&P MidCap 400, S&P SmallCap 600, and some other less widely known indices. In the background, we have roughly 30 committees covering markets and indices across stocks, bonds and commodities and just about any market anywhere in the world where a U.S. investor can buy or sell stocks, bonds or other investments. The U.S. committee and the S&P 500 is what most people talk about.
There are nine members on the U.S. Index Committee. Eight of the nine are full-time employees of S&P Dow Jones Indices, and the ninth is an attorney from McGraw-Hill Financial’s legal department [S&P DJI’s corporate parent]. The committee is focused exclusively on index management and calculation and has no commercial responsibilities. This way, we have no commercial conflicts and make all decisions based on investment issues only.
Decisions we make include how corporate events or actions affect the index. These include acquisitions, bankruptcies and just about anything else a company might encounter. For instance, if two companies in the index merge, we need to decide if the merged company remains in the index, select a new member and then follow the timing of the deal.
Once the committee’s decision is made, the transaction is monitored by the index manager who tracks the transaction thereafter. We publish a press release to our public website at 5:15 p.m. Eastern time usually five days after the decision has been made. All investors get the news at the same time.
Another thing we’ll do at a meeting is maintain a confidential list of candidate companies that we review and approve. For the S&P 500, there are usually about five to 10 approved names on the list.
Weiskopf: How did you go about making the decision to add Facebook to the S&P 500?
Blitzer: Facebook was probably the high-profile addition of 2013. The committee was familiar with Facebook. One of our requirements is that a company should have four consecutive quarters of positive earnings under generally accepted accounting principles, which sometimes makes us look sort of stubborn at times, but our experience is that it is not an unreasonable requirement for adding a company to an index.
Once a company is in the 500, if it had a bad quarter, we're not going to drop it immediately. Getting in is a little harder or restrictive than staying in. We were tracking Facebook for a while. Last fall, it passed the four-quarters rule.
Facebook is a big company, so we wanted to time the addition to when there would be a lot of liquidity in the market. One can’t add a company this big on a very slow trading day, like the day after Thanksgiving, for example. If one did that, the price would run up. Instead, we look for a day or days when we expect a lot of trading and only modest market impact.
Blitzer (cont'd.): The third Friday of the last month of the quarter is triple-witching Friday—the 20th of December in 2013. There is a huge amount of trading because index futures and options expire on that day. Those days are often good choices for large index changes because of the liquidity in the market.
When we decided to add Facebook—coincidentally on Friday the 13—we made the decision to provide seven days’ notice, more than the usual five days’, because we knew that the move would be perceived as an important addition.
Weiskopf: When a stock is added to the index, what determines its weight in the index?
Blitzer: The S&P 500, and most other indices, are market-cap-weighted, meaning each company’s weight is based on its market capitalization or value. A company’s value is the price of its stock multiplied by the number of shares. Its weight in the index is equal to its market value divided by the sum of the market values of all the companies in the index.
Three things about this approach: First, if a company’s stock price rises faster than the index rises, that company’s weight in the index increases and other companies’ weights decrease. Second, the index weights adjust to price changes all the time. Third, the S&P 500 and most other indices are float-adjusted, meaning we only count shares that are available to investors, the “float.”
For example, the Walton family owns a large part of Walmart, so their shares are excluded from the float and the index. In Facebook’s case, the weighting amounted to about 50 basis points.
Weiskopf: What made you remove Teradyne to make room for Facebook?
Blitzer: We run three indices—actually, we run thousands of indices, but we’ll talk about three—the S&P 500, which is usually viewed as large cap; the S&P MidCap 400; and the S&P SmallCap 600. From time to time, some companies do a little bit better or a little bit worse than typical in the index, and every so often it comes time to sort of shift a few names.
The announcement we made about adding Facebook to the S&P 500 included other changes to the S&P 500 as well as the S&P MidCap 400 and the S&P SmallCap 600. Teradyne was a company that hadn’t grown its market cap quite as fast as the 500 had overall, and was more appropriate for S&P Midcap 400.
This shifting, promoting and demoting, is an index change and is not an investment recommendation. Choosing a company for an index is not an investment opinion about the company.
Weiskopf: In the fixed-income area, what are the rules for removing credit from an index after it has been downgraded? Do all index providers follow the same standards?
Blitzer: Each index provider sets its own rules when it develops an index. Our index methodologies include the ratings required for a bond to be included in an index. The most common thing is to say it has to be investment grade, which would either mean BBB- and above, or BAA three and above, depending on which rating agency you're looking at.
Index methodologies usually cite two or three major rating agencies—Standard & Poor’s Ratings Services, Moody’s and Fitch—and will use the lowest rating among the agencies to qualify a bond. To be clear—S&P Dow Jones Indices operates separately from Standard & Poor’s Ratings Services.
Neither S&P DJI nor Standard & Poor’s Ratings Services has any access to any unpublished or private information that the other may have. We are walled off from one another. We are rating-agency neutral.
Weiskopf: So when somebody—Fitch—downgrades a credit and others haven't, how do you choose which one to follow?
Blitzer: Doesn’t matter which rating agency is first, second or third. When an index sets minimum rating such as BBB, the lowest investment-grade rating, we will follow whichever agency has the lowest rating on a bond.
For example, if Fitch rates a bond BB+ while S&P and Moody’s rate it BBB-, we will exclude the bond from an investment-grade index.
Weiskopf: How many indexes might there be available to be licensed?
Blitzer: The Dow Jones indexes business was combined with S&P Indices a couple of years ago, to form S&P Dow Jones Indices. When it was put together, we estimated that we had—after we got rid of a few overlaps—roughly 800,000 indices. From a practical point of view, if someone identifies a market or market segment and a way to represent that market, an index can be constructed and could be the basis of an investment product.
Weiskopf: There’s a lot of debate about “smart beta.” How would you describe a smart-beta ETF?
Blitzer: My description is that we look back at financial research that's been done, academic as well as practical, and in particular look at the work of Gene Fama, who’s one of the people who received the Nobel Laureate award in economics in 2013. Gene Fama, along with Kenneth French, wrote a series of papers on small-cap stocks and value stocks. What they found to be true consistently across different time periods and different markets around the world for equities was that over time, smaller-sized stocks outperformed larger-sized stocks, and value stocks outperformed growth stocks.
This is saying that if I re-engineer the standard market-cap-weighted index to overweight small-cap and value stocks, you would see stronger results.
One thing I would add is that the simplest way to do this is to weight all of the stocks equally instead of by market cap. In the S&P 500, this would be one-fifth of 1 percent, or 20 basis points, for each stock. The beauty of this strategy is that in two words I can describe the index—equally weighted. The simplest approach sometimes can be best understood.
Weiskopf: Should we look at a different label than “smart beta”? Should it be “alpha strategies”?
Blitzer: First of all, here at S&P Dow Jones Indices, we don’t like the term “smart beta” for exactly the reason you suggested.
I believe that investing with indices is smart. I would call it “intelligent investing.” I don’t like “passive investing.” It sounds like we all went to sleep. I think index investing is more intelligent than active management because you get to keep more of your money and you give away less in fees. And that, I’m willing to say, is smart.
Beta is what measures the change in your portfolio based on whether the market went up and down. Alpha is what measures the return of your portfolio based on how different you are from the market. And that’s the strict rule.
Dan Weiskopf is a portfolio manager of Access ETF Solutions LLC, whose third-party ETF strategies are offered through IPI Wealth Management, Inc. (IPI). IPI is an SEC-registered investment advisor, with its principal office located at 226 W. Eldorado St., Decatur, IL 62522, 217-425-6340. Access ETF Solutions LLC was established in 2013 with a focus that structure matters in selecting ETFs.
References to specific securities or market indexes are not intended as specific investment advice. All interviews have been approved for release by the individual and the individual’s affiliated firms, and the information is for institutional investors only. Readers are advised to read the full transcript of the interview including disclosures at accessetfsolutions.com or contact Dan Weiskopf at 212-628-4882.