AI Giants' S&P 500 Inclusion Debate and Index Mechanics Explained

The market is currently abuzz with discussions surrounding three major AI companies—SpaceX, OpenAI, and Anthropic—all poised to go public with anticipated trillion-dollar valuations. While the exact valuation remains a subject of debate, a parallel and equally fervent discussion revolves around their potential inclusion in the S&P 500. Given that the S&P 500 comprises the 500 largest market-cap companies in the US, these three companies would undoubtedly rank within the top 10.

Despite their size, many argue against their inclusion. This skepticism, however, often stems from underlying agendas.

Arguments Against Inclusion and Their Underlying Agendas

Three main groups voice opposition to the inclusion of these AI giants in the S&P 500:

1. Active Investors: This group, including institutional investors and mutual fund managers, has seen a significant loss of market share to passive investing. Their arguments often frame the inclusion of these companies as a risk to passive investors, using it as a platform to criticize passive investing in general.
2. Investment Experts and Academics: These individuals express concern that the inclusion of potentially "overpriced" and "money-losing" companies would blindsight retirees and small investors, leading to future losses. The underlying sentiment is that these investors are not equipped to understand the risks involved.
3. Politicians: Their opposition is simpler: these companies are owned by founders who will become billionaires, and billionaires are perceived negatively, thus their companies should not be rewarded with index inclusion.

Understanding Index Construction

To properly address the debate, it's crucial to understand how indices are constructed and their purpose.

Index Constituents

Indices are fundamentally about their constituents. The S&P 500, for instance, aims to represent large-cap US companies. While not strictly the 500 largest by market cap, it largely fulfills this goal. Other indices like the Dow 30, though older and less transparent in their selection process, also focus on large-cap companies. The number of available indices has proliferated over the past few decades, covering total markets, specific sectors, and different geographies (e.g., Sensex for India, Bovespa for Brazil).

Constituent Weighting

There are three primary methods for weighting companies within an index:

1. Equal Weighting: Every company is given the same weight, meaning smaller companies have a disproportionately larger impact on the index's performance.
2. Price Weighting: Found in older indices like the Dow 30, this method weights companies based on their share price, not their market capitalization. This can lead to counterintuitive results, where a company with a high share price but lower market cap might have a greater weight than a company with a lower share price but higher market cap.
3. Market Cap Weighting: This is the most common approach, where companies are weighted by their total market value (share price multiplied by the number of shares). The S&P 500 uses a "float-adjusted" market cap, meaning only publicly traded shares are considered, which can cause some companies to have a lower weight than their full market cap would suggest.

Index Level and Adjustments

The level of an index (e.g., S&P 500 at 7,554) is directly related to the aggregate market cap of its constituents. A conversion factor, known as "index units," allows for the translation of market cap into the index level. This factor is crucial for adjusting the index when companies are added or removed without causing an artificial jump or drop in the index level. For example, if a trillion-dollar company replaces a billion-dollar company, the total market cap of the index increases, but the index level remains the same due to an adjustment in the index units.

Indices of non-continuously traded assets, like real estate (e.g., S&P Case-Shiller Home Price Index), are more complex to measure as they rely on estimates and can experience lags in price adjustments.

The Purpose of Indices

Indices serve three main purposes:

1. Measurement Device: Historically, indices provided a single number to gauge overall market performance. The S&P 500, despite only including 500 companies, represents over 80% of the total market cap of US equities, making it an effective barometer for the US equity market. However, the "best" index depends on the specific question being asked (e.g., an equally weighted S&P 500 might better reflect the average stock's performance).
2. Performance Evaluator: Since the late 1960s, indices have been used to evaluate the performance of active money managers. Studies consistently show that a vast majority of active funds underperform the S&P 500, even when compared to style-specific index funds (e.g., large-cap growth funds against a large-cap growth index). This underperformance is a global phenomenon, observed even in markets like India.
3. Investment Vehicle: Jack Bogle's creation of the Vanguard 500 index fund in 1976 revolutionized investing by allowing individuals to invest directly in the index. The growth of index funds and ETFs has been exponential, with passive investing now dominating active investing. This shift is largely due to the transparent underperformance of active managers and the availability of low-cost index funds.

The Impact of Index Inclusion

The rise of passive investing has led to questions about the impact of a company's inclusion in an index:

• Stock Price Effect: While historically, inclusion in the S&P 500 was believed to boost a company's stock price, recent studies suggest this "inclusion bump" has largely dissipated. Companies often see a run-up before inclusion due to their growing market cap. The effect of being removed from an index still tends to be negative, though less so than in the past. The case of Tesla's inclusion in the S&P 500 in late 2020, which saw its stock price decline while the replaced company's stock rose, further illustrates the lack of a guaranteed positive impact.
• Momentum Effect and Market Top-Heaviness: A common argument against passive investing is that it creates a momentum effect, channeling funds into large-cap companies and making markets top-heavy. This is supported by observations like the dominance of "Magnificent Seven" stocks and the disappearance of the small-cap premium. However, this argument is met with skepticism:
  • Momentum based on fund flows should also work in reverse during outflows, leading to greater volatility in large-cap stocks.
  • The top-heaviness of markets can also be explained by the superior earnings growth of large-cap companies, particularly in winner-take-all industries driven by technology.
  • The idea that passive investing eliminates market efficiency by driving out active researchers is debatable, as much of active research is not truly original. The remaining active investors will likely be those who genuinely add value.

Protecting Retail Investors: A Misguided Argument

The argument that including companies like SpaceX in the S&P 500 would expose retirees and small investors to "hidden risk" is often presented with a tone of empathy but is fundamentally flawed:

• Diversification: An investment in the S&P 500, even with a risky company like SpaceX, diversifies that risk across 499 other companies. The individual investor is far less exposed than an active investor who might concentrate their holdings.
• Insulting to Investors: This argument assumes individual investors are uninformed and incapable of making their own choices. Many individual investors are aware of the companies in their index funds and may even want exposure to innovative companies like SpaceX.
• "Smart Money" Delusion: The notion of "smart money" (hedge funds, private equity) versus "stupid money" (retail investors) is a persistent delusion. Studies show that the average alpha for both private equity and hedge funds is negative. This distinction serves to justify high fees for active managers and allows individual investors to externalize blame for their own poor active choices.
• Company vs. Investment: The idea that a money-losing company is inherently a bad investment, or a profitable company a good one, is a misconception. A company's investment quality depends on its price. A money-losing company can be a good investment if priced correctly, and vice-versa.

S&P's Decision on SpaceX

Recently, the S&P announced it would not change its rules for inclusion, effectively delaying SpaceX's entry into the S&P 500 for at least 12 months. The existing rules require a company to have:

• A float exceeding 10%.
• Profitability in the four quarters leading up to inclusion.
• A large market cap.

While the float restriction is understandable (to ensure tradability), the profitability requirement is more contentious. It prevents innovative, high-growth companies that are reinvesting heavily from being included, even if they have immense market potential and large market caps.

S&P's decision, while framed as protecting individual investors, is likely a pragmatic move to avoid the massive adjustment challenges that would arise from simultaneously adding multiple trillion-dollar companies. However, this stance risks making the S&P 500 less representative of the largest market-cap companies if these AI giants continue to grow without being included.

Ultimately, the companies themselves (SpaceX, OpenAI, Anthropic) are unlikely to be significantly impacted by their inclusion or exclusion from the S&P 500. Their success will depend on their underlying business fundamentals. The index, however, needs these companies to maintain its relevance as a true reflection of the largest US equities. The ongoing debates often reveal underlying agendas rather than genuine concerns for market efficiency or investor well-being.