Massive megacap tech IPOs are prompting index providers to overhaul their rulebooks – what could it mean for investors?
FTSE Russell, Nasdaq and S&P Dow Jones are among the stock market index providers reviewing their IPO inclusion criteria ahead of hotly anticipated listings from the likes of SpaceX, Anthropic and OpenAI.
Several stock market index providers are re-evaluating their requirements to potentially fast-track newly listed megacap companies for inclusion on their major benchmarks.
Funds that track an index are obliged to buy all its holdings, although many providers have had a long ‘seasoning’ period in place – a time lag between a company’s Initial Public Offering (IPO) and it being included in a benchmark index that have typically ranged between three and 12 months.
Historically such rules have allowed companies to ‘settle in’, give the market time to digest and assess what they are worth. They also allow company management to adapt to the closer scrutiny that comes with being publicly traded as opposed to privately owned.
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While such criteria might come into active managers’ decision-making, passive funds don’t have the same discretion. If a company joins the S&P 500, any tracker funds replicating the index automatically have to buy its shares.
What changes are being proposed to index inclusion rules?
This month, Nasdaq introduced fast-entry rules allowing megacap stocks to be included in the Nasdaq-100 index of non-financial US-listed stocks after just 15 trading days, as opposed to a year under the previous rules. Updates have also included higher minimum value thresholds, higher liquidity requirements and stronger investor protection.
FTSE Russell, the provider of the Russell 3000, has also consulted on its listing rules for its Russell US Equity Indexes but is yet to publish its outcome.
It is focused on three main areas: fast entry for sizeable IPOs – as short a period as five days rather than waiting for the next annual update; a 5% minimum free-float rule (referring to the percentage of shares available for public investors to buy and sell); and a 5% minimum voting rights rule (meaning public shareholders must collectively have at least 5% of the company’s voting power).
S&P Dow Jones Indices (S&P DJI) – the provider of the US flagship index, the S&P 500 – is currently holding an industry consultation to gather feedback on eligibility rules for megacap companies. It’s also mooting a shorter seasoning period, reducing it from 12 to six months.
It currently defines megacaps as those with market valuations falling in the top 100 constituent companies, although this is also up for review.
In its consultation paper, S&P DJI said: “The proposed criteria exceptions and changes to the S&P 500, S&P MidCap 400 and S&P SmallCap 600 apply only to eligibility determination.
“Therefore, if any of the proposed changes are adopted, such changes would not result in a megacap company’s automatic inclusion within those indices. New constituent selection for those indices remains at the discretion of the Index Committee, subject to the relevant index methodology.”
Requirements on profitability and liquidity for large companies are also under review.
S&P DJI’s consultation is set to close on 28 May. Any changes will take effect before the market opens on Monday 8 June, unless otherwise stated.
Could SpaceX join the S&P 500 when it IPOs?
Record IPOs – like those anticipated by SpaceX, Anthropic and OpenAI – pose unique challenges for index methodologies as they currently stand.
Current estimates are suggesting SpaceX could float with a market capitalisation of between $1 and $2 trillion. FTSE Russell suggested OpenAI could list with a market cap of around $1 trillion and Anthropic around $350 billion. It’s worth remembering that float dates have not yet been set and suggested values and IPO levels are purely speculative.
The providers agree their previous benchmark rules were set up in a very different IPO environment, with more conventional listing profiles. All proposed changes look intent on improving liquidity, fairness and governance standards for index investors.
Market research firm Morningstar, which acquired the Center for Research in Security Prices (CRSP) in February, now benchmarks the entire US equity market, spanning market caps, investment styles and sectors.
It said it was important to adjust eligibility rules so its benchmarks remained relevant to new market realities.
Alex Bryan, director of global equity indexes at Morningstar, said: “The picture here is not radically changing. Even without any changes, a company like SpaceX would probably work its way into all the major indexes eventually. And when companies are added to indexes, I think that only helps deepen the liquidity and improves price discovery. It’s just that instead of being included in months or a couple of years, they could be compressed to a couple weeks or a few days.”
When companies are held private for longer, much of their growth happens before mainstream investors can gain ready access. Bryan said these proposed changes should give passive investors comparable access to active managers.
Most index providers have methodologies designed for much smaller IPOs. Historically, providers required companies to have a certain proportion of their shares available to be freely traded (free float) – before they would be added to an index. Morningstar’s free-float threshold is set at 10% of total market capitalisation, for example.
But a company like SpaceX could have a relatively small IPO in percentage terms and still be one of the largest and most significant companies in the world.
Bryan said: “One of the requirements that Morningstar and others have had is that a new company coming in has to have a certain percentage of their total market cap in free flow to qualify. And 10% of close-to $2 trillion valuation is higher than the IPO that SpaceX is planning to come to market at.
“There’s a recognition across the industry that the historical legacy approach didn’t really anticipate these megacap IPOs at these enormous valuations; they were meant to sidestep thinly-traded small cap stocks.”
The team also made the point around liquidity and transaction costs. Share prices can become volatile around an IPO, leading to price uncertainty and potentially higher trading costs for investors.
But Alex Poukchanski, director of index analytics for Morningstar Indexes, pointed to recent evidence suggesting such volatility typically settles within a few days, especially for very large IPOs, reducing the likelihood of higher transaction costs.
What could a change in index inclusion rules mean for investors?
With private companies remaining private for longer, it’s understandable that stock exchange providers have been keen to reignite flow towards public markets; one way of doing so is to relax some of the headline rules.
“It does make [an IPO] more attractive – particularly for more entrepreneurial companies,” said Dan Coatsworth, head of markets at investment platform AJ Bell.
Coatsworth added that if the likes of SpaceX are listed quicker, it opens up a whole wave of buying from tracker funds as soon as they land on the stock market.
“The last thing any company wants is to join the stock market, not see any interest in its shares and the share price just drifts away,” he said.
While SpaceX, Anthropic and OpenAI have been the names in recent focus, their experience might well pave the way for smaller companies.
One potential trade-off is the chance of sharp share price movements in the early stage after being added to an index.
“You’ll get loads more buying but that could also prompt some investors who got in quickly, looking to trade on a short-term basis, which might trigger massive volatility.”
