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The Short Answer

How Did Facebook End Up in the S&P 500?

We dive into the process for adding companies and booting them from the iconic index.

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Question: I heard that  Facebook (FB) will soon be added to the S&P 500 even though the company went public just last year. What are the rules regarding when a company joins or leaves the index?

Answer: Given the S&P 500's role as one of the most widely used measures of U.S. stock market performance, one might assume that the index's composition doesn't change much from year to year, but that's not necessarily the case. In fact, this year alone the S&P 500, which tracks the stocks of many of the largest U.S. companies and weights them by market value, has already swapped out 15 constituent companies in exchange for others.

Companies added in 2013 include clothing maker Michael Kors Holdings (KORS), Delta Air Lines (DAL),  News Corp (NWSA), oil-services company  Transocean (RIG), and  Vertex Pharmaceuticals (VRTX). Meanwhile, those leaving the index included Dell,  Sprint (S),  J.C. Penney (JCP),  Dean Foods (DF), and NYSE Euronext. The index will change further Dec. 20 as social-media giant Facebook, marketing and loyalty-program services firm  Alliance Data Systems (ADS), and flooring manufacturer Mohawk Industries (MHK) join the index, replacing  Teradyne (TER),  Abercrombie & Fitch (ANF), and JDS Uniphase (JDSU).

Rigid Criteria Determine Who's In, Who's Out
Many people incorrectly assume that the S&P 500 measures the stock performances of the 500 largest U.S. companies. But some large companies are not publicly traded and thus are not included, or they are removed from the index when they are taken private, merge with, or are taken over by other companies. For example,  Berkshire Hathaway (BRK.A) (BRK.B) acquired food company H.J. Heinz, a former S&P 500 constituent, earlier this year, making the latter firm's inclusion in an index of investable stocks irrelevant.

According to the S&P Dow Jones Indices website, the composition of the S&P 500 is maintained by a committee of economists and analysts whose goal is "to ensure that the S&P 500 remains a leading indicator of U.S. equities, reflecting the risk and return characteristics of the broader large-cap universe on an ongoing basis." 

To be included in the index, companies must meet the following criteria:

  • Must be a U.S. company
  • Must have a market capitalization of at least $4.6 billion (the limit as of September but subject to change)
  • At least 50% of the company must be publicly held
  • Must have four consecutive quarters of positive reported earnings
  • Stock must be relatively liquid, trading at least 250,000 shares per month for six months
  • Company must contribute to the index's sector balance
  • Must be listed on the New York Stock Exchange or Nasdaq, or be a nonmortgage REIT or business-development company

Companies may be booted from the index for violating any of the above criteria. For example, J.C. Penney, the struggling department store chain that has seen its market cap plummet from $7.5 billion to $2.6 billion in just two years, got the boot last month (at the same time it was added to the S&P MidCap 400 Index). These criteria also came into play during the late 1990s, when many tech companies saw their stock prices soar, lifting their market capitalizations to well within range of the index. Yet those companies were left out because they didn't meet the index's profitability rules.

The index committee takes into account short- and medium-term historical market-cap trends for a company and its industry before adding it to the S&P 500. The index's methodology states that following an IPO, companies must wait at least six to 12 months before being considered for the index. Members obviously believed that Facebook, with a market cap of around $130 billion, was ready despite its relatively short history as a public company; Facebook's IPO took place in May 2012. Changes to the index are made as needed and not on any set schedule, according to the methodology.

Even Index Investors Need to Know What They Own
The S&P 500's significance for stock investors is hard to overstate. Not only is it a widely used benchmark for the performance of the U.S. stock market (the Dow Jones Industrial Average gets more media attention, but the financial industry tends to prefer the S&P 500 partly because of its broader diversification). But many U.S. investors rely on S&P-tracking mutual funds and exchange-traded funds as core holdings to diversify their portfolios. Indexing is becoming an increasingly popular investment strategy, and one third of all index mutual funds track the S&P 500, according to the Investment Company Institute. And that doesn't even include the many ETFs tracking the index. In fact  SPDR S&P 500 (SPY), an ETF that tracks the index and has more than $160 billion in assets, is among the largest funds or ETFs of any stripe.

Given that so many investors rely on funds or ETFs that track the S&P 500, company movements into and out of the index are worth noting. It's not that the addition of a single company such as Facebook in itself is likely to make a huge difference to index investors' portfolio allocations--even the S&P 500's biggest constituent,  Apple (AAPL), represents only about 3% of its holdings these days. But it will add a bit to the index's tech-sector weighting. For investors who use S&P 500 index funds and ETFs as core holdings, such subtle shifts are worth paying attention to, not as portents of problems down the road, but rather as an act of due diligence. An S&P 500 index fund is a great way to achieve portfolio diversification in one easy package--and often at a bargain-basement price. Just pay attention to what's inside that package as it changes. After all, you may think you're investing in an index, but what you really own are small stakes in the many stocks of which it is composed. If you don't pay attention to this, then you don't really know what you own.  

Finally, investors owning individual U.S. large- and mid-cap stocks also would be wise to note changes in the makeup of the index as they can affect the values of their holdings. For example, a stock that is added to an index may see its share price go up as a result of new demand from funds and ETFs that must buy shares to replicate the index. The opposite may happen when a stock is dropped from an index.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.

Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.