How S&P 500 stocks are selected

The Standard and Poor’s 500, or simply the S&P 500, is a stock market index comprised of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. The S&P 500 index is a free-float weighted/capitalization-weighted index. Although the index includes only companies listed in the United States, companies in the index derive on average only 72% of their revenue in the United States.

The index is one of the factors in computation of the Conference Board Leading Economic Index, used to forecast the direction of the economy. The index is associated with many ticker symbols, including: ^GSPC, INX, and $SPX, depending on market or website. The S&P 500 is maintained by S&P Dow Jones Indices, a joint venture majority-owned by S&P Global, and its components are selected by a committee.

How the S&P 500 index is calculated

The index is a free-float capitalization-weighted index; that is, companies are weighted in the index in proportion to their market capitalizations. For purposes of determining the market capitalization of a company for weighting in the index, only the number of shares available for public trading (“public float”) is used; shares held by insiders or controlling shareholders that are not publicly traded are excluded from the calculation.

The formula to calculate the S&P 500 index value is:

where is the price of the i-th stock in the index, is the corresponding number of shares publicly available (“float”) for that stock, and is a normalization factor. The is a number that is adjusted to keep the value of the index consistent despite corporate actions that affect market capitalization and would otherwise affect the calculation formula, such as additional share issuance, share buybacks, special dividends, constituent changes, rights offerings, and corporate spin-offs.

Stock splits do not affect the divisor since they do not affect market capitalization. When a company is dropped and replaced by another with a different market capitalization, the divisor needs to be adjusted in such a way that the value of the S&P 500 index remains constant. All divisor adjustments are made after the close of trading and after the calculation of the closing value of the S&P 500 index.

How to invest in the S&P 500

Here are the ways you can invest in the S&P 500.

a. Mutual and exchange-traded funds

The easiest way to invest in the S&P 500 is to buy an index fund, either a mutual fund or an exchange-traded fund that replicates, before fees and expenses, the performance of the index by holding the same stocks as the index, in the same proportions. Exchange-traded funds (ETFs) that replicate the performance of the index are issued by The Vanguard Group (NYSE Arca: VOO), iShares (NYSE Arca: IVV), and State Street Corporation (NYSE Arca: SPY).

These can be purchased via any electronic trading platform or stockbroker. In addition, mutual funds that track the index are offered by several issuers including Fidelity Investments, T. Rowe Price, and Charles Schwab Corporation. Direxion offers leveraged ETFs that attempt to produce 3x the daily result of either investing in (NYSE Arca: SPXL) or shorting (NYSE Arca: SPXS) the S&P 500 index.

b. Derivatives

In the derivatives market, the Chicago Mercantile Exchange (CME) offers futures contracts that track the index and trade on the exchange floor in an open outcry auction, or on CME’s Globex platform, and are the exchange’s most popular product. Ticker symbols are /SP for the full-sized contract and /ES for the E-mini S&P contract that is one fifth the size of /SP.

The CME also trades a Micro E-mini futures contract that is one tenth the size of the S&P E-mini contract, i.e. 1/50 the size of the full-sized (SP) contract. The Micro E-mini S&P 500 Index contract’s ticker symbol is /MES. The Chicago Board Options Exchange (CBOE) offers options on the S&P 500 index as well as on S&P 500 index ETFs, inverse ETFs, and leveraged ETFs.

How S&P 500 stocks are chosen

The components of the S&P 500 index are selected by a committee. When considering the eligibility of a new addition, the committee assesses the company’s merit using eight primary criteria: market capitalization, liquidity, domicile, public float, Global Industry Classification Standard and representation of the industries in the economy of the United States, financial viability, length of time publicly traded, and stock exchange.

To remain indicative of the largest public companies in the United States, the index is reconstituted quarterly; however, efforts are made to minimize turnover in the index as a result of declines in value of constituent companies. A stock may rise in value when it is added to the index since index funds must purchase that stock to continue tracking the index.

Requirements to be added to the S&P 500 index include:

a. Market capitalization

The S&P 500 is supposed to represent the largest U.S. companies, so naturally size is an important component. Size, in this case, is determined by the company’s stock market value, or market capitalization, which is the total value of all its shares outstanding.

b. Profitability

With few exceptions, companies must be profitable to get into the S&P 500 index. Profitability is measured in two ways: over the last four quarters and in the most recent quarter.

c. Float

Annual dollar value traded to float-adjusted market capitalization is greater than 1.0. The purpose of the S&P 500 is to track large-cap stocks that you can actually invest in. To that end, it has some rules that disqualify companies that are closely held (majority owned by only a few shareholders) as well as companies that are thinly traded (companies whose shares have very little trading volume). 

To get into the S&P 500, a company needs to have at least 50% of its stock “floating” on stock exchanges. A company that is 60% owned by its founder, for example, is arguably more “private” than “public” from an ownership perspective, given that only 40% of shares are in the hands of the investing public. 

d. Liquidity

A company’s stock must be liquid. Each year, trading volume must exceed 100% of its float, and a minimum of 250,000 shares must trade in the 6 months leading up to the evaluation date. So if a company has 1 billion shares in the float, at least 1 billion shares must trade hands each year.

e. A U.S. company

The S&P 500 is meant to track large businesses that operate in the United States. To that end, it requires that companies meet some criteria for being U.S. businesses. A company must:

• File 10-K annual reports with the SEC.
• Have a “plurality” of assets and revenue in the United States.
• List on an eligible exchange (basically, any of the large exchanges such as the NYSE or NASDAQ).

The threshold for having a “plurality” of assets and revenue from the United States is not strictly defined. Companies may register overseas for tax purposes but still be considered U.S. companies for the purposes of getting into the S&P 500. Perhaps the strictest rule is whether the company is listed on a large U.S. exchange and filing 10-K annual reports. The S&P 500 does not allow any companies that trade over the counter or on the pink sheets to get in.

f. Publicly listed company

Must be publicly listed on either the New York Stock Exchange (including NYSE Arca or NYSE American) or NASDAQ (NASDAQ Global Select Market, NASDAQ Select Market or the NASDAQ Capital Market). Companies that have recently gone public in an IPO must have at least 12 months of trading history on a large exchange, so a profitable company that goes public can’t immediately hop into the S&P 500 based on its earnings before its IPO.

g. Ineligible companies

The S&P 500 only includes ordinary corporations and real estate investment trusts (REITs). Securities that are ineligible for inclusion in the index are:

• Business development companies (BDCs)
• Limited liability companies (LLCs)
• Limited liability partnerships (LLPs)
• Master limited partnerships (MLPs) and their investment trust units
• OTC Bulletin Board issues
• Closed-end funds (CEFs)
• Exchange-traded funds (ETFs) 
• Exchange-traded notes (ETNs)
• Royalty trusts
• Tracking stocks
• Preferred stock
• Unit trusts
• Equity warrants
• Convertible bonds
• Investment trusts
• American depositary receipts (ADRs)
• American depositary shares (ADSs)

h. Committee decision

Meeting all the basic requirements isn’t enough; companies must get the approval of the index committee to get into the S&P 500, making it more of an “active” index than other indexes that simply use mechanical rules to pick stocks. The S&P 500 is supposed to be representative of the U.S. stock market. The committee, by adding or removing stocks strategically, can ensure the S&P 500 doesn’t differ meaningfully from the whole market. A lot of money is invested in funds that track the S&P 500, so it’s important to investors that the index accurately reflects the market.

Removal of a company from the S&P 500

Turnover in index membership is avoided when possible. At times a stock may appear to temporarily violate one or more of the addition criteria. However, the addition criteria are for addition to an index, not for continued membership. As a result, an index constituent that appears to violate criteria for addition to that index is not deleted unless ongoing conditions warrant an index change.

Understandably, adding and removing companies from the S&P 500 is a big deal. With so many funds tracking it, changes can result in huge trading volumes as index funds sell stocks that are removed and purchase stocks that are added. Changes in the index can also trigger capital gains taxes for their investors, which is why many indexes and index funds seek to minimize turnover when possible.

The people who make up the index committee are some of the most influential people in the financial markets, responsible for decisions that can have billion-dollar consequences for investors. At times, the committee has taken an active role in “managing” the index’s composition instead of simply removing a company from the index, as this may negatively affect the company and the shaky financial markets. In general, it’s much harder to get kicked out of the S&P 500 than to get in.