The criteria used in compiling the Fortune 500 are rigorously followed by the Fortune Index Committee, resulting in the index being objectively derived and completely transparent with respect to its constituents. The index requires little maintenance because components removed are not replaced. A company may be removed during the year if it violates any of the eligibility criteria. Similarly, a company may be added if has an initial public offering and meets the eligibility criteria. Once removed, components may be considered for re-inclusion in the index the next year during annual reconstitution (which occurs after the close of trading on the third Friday in April following publication of the Fortune 500 List), provided these companies are on that year's Fortune 500 List. Year-to-year maintenance is minimal due to the index's low turnover, a result of companies able to produce large revenues in one year and repeating the feat in subsequent years. According to Fortune Indexes, the Fortune 500's annualized market capitalization turnover was 4.34% from 2000 to 2002.
Since only public companies meeting the eligibility criteria are selected from the 500 list, the index ordinarily contains fewer than 500 components. Because the index committee does not replace components removed because of rule violations, the index usually ends each year with fewer components than when it began. For example, the index began its year with 443 components on April 23, 2001, dropped 23 and ended its year with 420 on April 19, 2002. A few days later, on April 22, 2002, at annual reconstruction, the index included 451 companies, which were reduced to 441 by June 30. However, as mentioned earlier, certain corporate actions, such as initial public offerings and spin-offs, have the potential of increasing the number of components in the Fortune 500 throughout the year.
S&P 500 Index
The S&P 500 index has had a long tenure as a stock market indicator. Seeking to portray the average experience of those investing in U.S. stocks, Alfred Cowles pioneered the index's methodology beginning in 1913. His original study was designed to calculate the average price change and other related statistics for a cap-weighted basket of all stocks listed on the New York Stock Exchange beginning in 1871-a Herculean task, given the paucity of computing resources available. His efforts led to the development of the forerunner of the S&P 500 index in 1923, when Standard & Poor's introduced a new methodology for evaluating stock performance called the "base-weighted aggregate technique" and a series of indexes that included 233 companies grouped into 26 industries.
Today, the S&P 500 is still cap-weighted, but is limited to 500 stocks in 10 economic sectors. According to Standard & Poor's, "The 500 companies chosen for the S&P 500 Index are not the largest companies in terms of market value, but rather, tend to be leaders in important industries within the U.S. economy."
The S&P Index Committee governs the index's composition to maintain the S&P 500 as an appropriate benchmark for the performance of the U.S. equity market. Before 1982, the committee's primary function was to find replacements for companies that filed for bankruptcy protection or ceased to exist because of merger-related activity. Since then, the committee has tried to maintain "a flexible approach to managing the index ... The Committee does not establish a rigid set of rules that must be followed without concern for impact on the marketplace ... Maintaining stability of the population of companies within the S&P 500 Index is of primary consideration. Excess company turnover impacts the statistical validity of the Index as a gauge of Market performance."
Notwithstanding the stated intentions of the S&P Index Committee, considerable debate persists on whether the S&P 500 is any longer an appropriate asset class proxy for big companies in the U.S. stock market. Since the 1960s, the vast majority of academic and institutional studies have used the S&P 500 as the benchmark most suited to representing the U.S. stock market. Today, we evaluate the extent to which this choice is still appropriate.
Evaluation Criteria
Establishing precise criteria to intelligently evaluate and identify the best available proxy for large U.S. stocks is critical. One cannot evaluate what one cannot measure. We evaluated the indexes based on five criteria that compare their relative merits as asset class proxies for today's U.S. large-cap blue-chip stocks. They are:
1) consistency and objectivity;