Will Tesla Break The S&P 500?(Part 2) – The Mechanics Of Market Turmoil
- “Additions and subtractions to the S&P 500 are normally a ho-hum affair. The 509th biggest company in the U.S. might jump to 497th place, and thus into the index. Investors who track it buy the one stock and sell another. But no one has ever tried to add a Tesla… That’s happening next month, and it’s causing headaches across Wall Street.” – The Wall Street Journal (Nov 29, 2020)
Tesla is by far the largest company – in terms of market capitalization – ever to join the world’s most important equity benchmark, the S&P 500 Index.
- It enters as the 6th heaviest-weighted component of the index
- It is 3 times the size of the largest previous addition (Berkshire Hathaway, in 2010)
- Its market cap is hundreds of billions of dollars higher than that of the largest bank (JP Morgan), the largest energy company (ExxonMobil), the largest automaker (Toyota), or the largest pharmaceutical company (Pfizer)
Adding a company of this size to the index is not just a matter of appending a new name to the list. It has to be fitted into the index structure, officially displacing one component company, and impacting many others, to make room. Following a 70% surge in its price over the 5 weeks preceding the day of its inclusion (Dec 21), Tesla’s index weight reached 1.6%. That is, its (float-adjusted) market capitalization was equal 1.6% of the total value of all 500 companies in the S&P 500. It has since risen to 1.7% (as of Jan 4). That may not sound like much, but it is greater than the combined weight of the 75 smallest members of the index.
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Such a large addition also stirs up the broader market, in interesting ways, unleashing torrents of buying and selling. Some of these trades are forced – that is, obligatory, non-optional – and some are discretionary, and opportunistic.
To start with, the index restructuring arising from Tesla’s addition resulted directly in a great deal of forced buying, driven mainly by the fact that index-tracking investment funds now have to add Tesla to their portfolios at the appropriate weight. For example, the Vanguard S&P 500 index fund – the original passive index-tracking investment vehicle – has assets of over $600 Bn. To bring Tesla up to 1.6% of its portfolio, Vanguard has to buy about $10 Bn worth of Tesla shares. And it has to sell $10 Bn worth of other companies’ shares to make room.
Across the market – where passive indexing funds play a larger and larger role – the numbers are huge. According to Barron’s, “between $5 trillion and $6 trillion are invested in funds indexed to the S&P 500.” These funds will have had to acquire around 120 million shares of Tesla, worth $80-100 Bn, and divest $80-100 Bn of other holdings, to align their portfolios with the new index composition.
There is more.
- “Index funds won’t be the only ones affected—another $6.7 trillion in actively managed funds use the S&P 500 as their performance benchmark.”
Benchmarking refers here to a practice characteristic of many investment funds that (in principle) exercise active management, analyzing and selecting specific stocks (unlike purely passive index-tracking funds which have no choice as to what they must own). Benchmarking funds explicitly measure their performance against a defined market index like the S&P 500. Managers of these funds do not want to deviate too much from the benchmark, especially on the downside. Thus, they are also sensitive to changes in the composition of the index. Indeed, some “active” funds use the benchmark as a more than just a point of reference.
- “Stock pickers mimicking the index is called closet indexing. Managers are closet indexers because they don’t want to lag too far behind the benchmark for fear of losing their jobs or their funds have gotten so big that they can’t help but track the market.”
“Closet indexing” is the subject of much criticism. Although it is not easy to measure, it is said to be fairly common. A European study estimated that 15% of all active investors are really closet-indexers.
It is hard to say how much quasi-forced trading volume Tesla may have generated among active and pseudo-active investment funds, but it is not small. Goldman Sachs estimated that “actively managed funds benchmarked to the S&P 500 will buy $8 billion of Tesla shares.” (This seems low, if closet indexing is as prevalent as the studies indicate.)
There is still more (as per Goldman):
- “The Tesla move will also spur trading within separately managed accounts [i.e., customer portfolios rather than general investment vehicles] that use the S&P 500 as a benchmark, as well as hedging activity by trading firms that buy and sell ETFs.”
It is hard to imagine that any fund manager, or asset manager, who leans in the direction of benchmarking could ignore the Tesla move.
Speaking of ETFs (exchange traded funds, another type of passive index-tracking vehicle), there are at least 121 ETFs that include Tesla among their top 15 holdings (with some portfolios giving Tesla as much as a 15% weighting).
It is likely that at least $100-150 Bn of buying volume in Tesla shares (and an equal amount of selling volume in other companies’ shares) was generated directly by the index restructuring in the overall market in the week before the Effective Day (Dec 21).
Is there even more to come?
- “Goldman Sachs analysts surveyed the managers of 189 large-company mutual funds and found that 157 of them—managing some $500 billion in assets—didn’t own any Tesla shares as of Sept. 30. Applying that rate to all the actively managed assets benchmarked to the S&P 500, if just a small group of active managers decided to match up with the index’s Tesla exposure, it would be another pool of massive demand for the stock.”
The crucial fact is that the index funds have no choice (and the closet indexers may feel much the same way). They trade simply because the index composition has changed. Bloomberg calls it “mechanical buying.”
It is also price-insensitive buying – that is, the buying decision is not motivated by, and does not reflect, the buyer’s assessment of the asset values underlying the market prices (an important subject we will come back to in Part 4 of this series).
Beyond this obligatory trading, the Tesla situation has also stimulated huge volumes of active, discretionary trading which aims to take advantage of the involuntary nature of the index-funds’ buying.
Discretionary Trading Strategies
Many active investors are event-driven investors – that is, they observe and react to important news “events.” They track the way in which the market processes new information of various sorts, and seek to trade profitably on the price movements that develop.
A change in the composition of an important index is one such “event.” It signals a predictable surge in demand for the shares of the company joining the index in the near future (resulting from the forced buying described above). The scale of the buying can be calculated. The timing is known. And the index funds (and closet cousins) can’t react right away. They can’t just buy their quota on the Announcement Date (AD), because the weighting won’t be fixed until the Effective Date (ED). They have to buy the shares they need as close to the ED as possible, to minimize tracking error.
“Front-Running” the Index Funds (Legally)
This creates an opportunity for active investors to take advantage of the index-funds’ lack of flexibility. Once the announcement of Tesla’s forthcoming inclusion in the index is made public, the “mechanical buying” that index-tracking funds will be forced to carry out becomes in effect a fait accompli. It is a certainty that the passive funds will be forced to buy $50 Bn, $80 Bn, perhaps $100 Bn worth of Tesla (depending on the share price on the effective date). With that knowledge, active investors can start to position themselves to profit from this surge in involuntary demand. They can buy at the November price and hope to sell to the captive buyers at the December price.
In effect, the actives can front-run the passives.
Front-running is an ancient part of the trading repertoire. It refers to buying (or selling) ahead of a known large order, to profit from the price movement that this order will create. It is normally seen as an illegal activity:
- “Front running is the prohibited practice of entering into a trade to capitalize on advance, nonpublic knowledge of a large pending transaction that will influence the price of the underlying security.”
But in the Tesla case, the approximate size and timing of the large future orders that the index-tracking funds will have to place are known to all the world. There is no “inside information” problem. Starting with the day of the announcement, the outcome is scripted. An active investor can freely buy in front of this forthcoming demand, and sell into it when it materializes. The 35 days between the Announcement Date (AD) and the ED is a godsend for the actives. Plenty of time to buy now and sell later to a counterparty who will have to pay the market price, whatever it is. (By the way, this 35 day window is quite long. We’ll address the significance of this in the next column.)
And, it is entirely legal.
Even better — it is self-fulfilling. The more that these legal front-runners buy, the more the price is driven up, the greater the weight Tesla will have in the index when it does join, the more shares the passive index-tracking funds will have to buy, and the more the legal front-runners stand to profit from selling those shares to the hapless passives.
Tesla experienced just this kind of self-reinforcing trend (called “pro-cyclical” by finance specialists) in November and December.
The average gain in price for the shares of companies added to major indexes during the “front-running” period in normal cases is economically significant, but modest. A Federal Reserve study of the “S&P 500 effect” for 400+ stocks added to the index over a 20-year period found an average of a 6% gain (above the market average) between the AD and the ED.
In Tesla’s case, the company’s huge size was an accelerant. As noted, the AD-to-ED share price gain topped 70%. The average daily volume in the AD-ED period was 60 million shares, compared to 29 million shares a day in the month prior to the AD. Active investors were able to load up on the shares they knew the passive index-funds would have to buy from them by the ED. There was clearly a powerful pro-cyclical effect at work.
“Gaming” Index Membership Changes
There is another sort of active investing strategy associated with changes in index membership, where investors attempt to anticipate the additions and deletions from the index before they are announced. This may be possible where the rules for inclusion in an index are straightforward and known to investors, who can build their own models to predict which companies will be involved in the membership changes. They can invest ahead of the predicted announcement, and if they are correct they benefit from the AD 1-Day bounce (4% in the Federal Reserve study) as well as the AD-ED gains.
The Russell 2000 – the leading U.S. small cap index, managed by FTSE/Russell (a subsidiary of the London Stock Exchange) – employs an open and transparent methodology for determining membership. This may make it vulnerable to this sort of front-running, as the Financial Times reported in 2015, prior to the annual June reshuffling of the index.
- “The disadvantage of transparent, rules-based indices [is that] they can be gamed, to the detriment of index-trackers. The 120 or so stocks being added to the Russell 2000 this year entered Friday up an average of 11 per cent over two months. Most of this advance was in May, as traders worked out who the new members would be.”
Once again, this sort of front-running is perfectly legal. Whether it represents a flaw in the indexing system used by FTSE Russell is a subject for interesting debate. Apparently, however, the secrecy surrounding the exact nature of the S&P decision process negates any opportunity for “gaming” the S&P 500, according to a 2017 study.
- “There is no evidence of significant abnormal returns before announcement, apart from a marginal average price increase of 0.36% four days before. This result may suggest that the market may have not anticipated the event, consistent to the fact that S&P 500 re-composition dates are not known in advance.”
That said, the huge disappointment reaction in Tesla’s shares in September — Tesla’s price fell 21% in a single day after it was announced they would not be joining the S&P 500 quite yet – suggests that in Tesla’s case the gamers probably were actively trying to guess the S&P’s moves.
Managing the Tesla Event
The market seems to have struggled to absorb the stresses of these processes.
The self-reinforcing “front-running” cycle built up over several weeks, and then discharged its force in the last week of the run-up to effective date, as the passives finally began buying to accumulate their required portfolio positions. Because of the surge in Tesla’s price, and the extraordinary scale of the “mechanical” trading activity, the index-fund buying appears to have been highly concentrated towards the Dec 18 deadline (the last trading day before the inclusion went effective before the market opened on Dec 21). Over 200 million shares traded, reaching a violent climax in the final minutes, including 69 million shares ($50 Bn) just in the electronically managed closing print – which sets the benchmark for the index-tracking funds. The share price gyrated wildly in the final moments. Bloomberg headlined their story: “Hungry Index Funds Cram Tesla Into the S&P 500 at a Record High.”
- “Frantic purchases by passive managers drove the shares almost 5% higher just as markets closed.”
The effects were not confined to Tesla’s shares:
- “Ramming Tesla into the S&P 500 was expected to cause dislocations for other companies as index-fund managers shifted holdings to make room.”
Ramming, cramming, dislocations, passives gone frantic – “the perfect storm for speculators…” It was also a fascinating experiment that illuminated some of the risks and challenges of managing an index.
S&P seems to have understood the risks, and to have anticipated the challenges. They made several interesting moves to mitigate the disruptive effects of the Tesla addition. In the next part of this series, we’ll look at some of the unusual, and in some cases unprecedented, measures that the index managers undertook to ensure that the S&P 500 could safely swallow even as big a fish as Tesla.