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Tesla’s Rise Reveals Weak Points of Indexing

Written by Michael Beech on April 12th, 2021.      0 comments

Index additions and deletions are typically a routine affair

But the recent announcement by S&P that Tesla would be added to the widely tracked S&P 500 Index stirred up quite a lot of attention.

No surprise, given that Tesla is the largest company to ever join the index and, at the time of its addition on December 18, 2020, became the sixth-largest company in the S&P 500. On news of the announcement on November 16, Tesla’s stock price jumped 8.2% from $408.09 to $441.61. Tesla then continued to post strong returns, closing December 18 up 70.3% since the announcement. That made the 2.3% return to the S&P 500 Index1 over that period look meagre by comparison.

While Tesla’s stock price wowed investors ahead of the company’s addition to the S&P 500, the pattern quickly reversed: the stock climbed 13.9% over the five days ending with its index addition on December 18 yet slumped 4.8% over the subsequent week.2

Indices generally undergo regular reconstitution events during which securities are added or deleted. Index funds, constrained by the objective of maintaining low tracking error versus the index, generally have to mirror these changes by purchasing and selling securities based on the revised index weights. With over $4.6 trillion in assets tracking the S&P 500 as of year-end 2019, that implies many index funds sought to buy Tesla stock on the day it was officially added to the index.3

Index funds are often promoted as a good way to get passive exposure to the stock market as a whole. However, we suggest that being completely passive is not necessarily a good thing.

For passively managed index funds, their lack of flexibility can come at a cost.

One way to assess this potential cost is to examine the extent to which index reconstitution events are associated with unusually high trading volume. Abnormally high trading volume is an indication that demanding immediacy to trade in such stocks in the same direction may be costly.

Dimensional Fund Advisers recently researched this topic and they illustrate such abnormal trading volume in Exhibit 1, which compares trading volume in stocks added to or deleted from the S&P 500 on reconstitution day with trading volume in the same stock on days before and after the reconstitution day. Dimensional find that trading volume for rebalanced stocks spikes more than 25 times relative to volume over the prior 40 days.

Exhibit 1

0321 Mike Beech graph

Demanding such unusually large trade volume can result in price pressure and invariably leads to index funds buying stocks at inflated prices.

The reconstitution effect is one example showing the lack of flexibility of an index approach, which can leave returns on the table.

Whilst a passive investment approach that aims to hold the market portfolio can be a good, diversified way for retail investors to get exposure to shares, it’s always important to understand the detail and when digging a bit deeper we conclude that an index fund may not necessarily be the most efficient way of achieving this objective.

We believe a better approach is using a passive fund that aims to buy all stocks available, not just those in an index, and has flexibility at the point of trade execution across stocks and quantity. Such an approach allows investors to incorporate information about liquidity and trading costs as well as avoid the cost of demanding immediacy from the market. A daily investment process also allows for the incorporation of short-term information about expected returns that is relevant over days or months, such as momentum and information from securities lending fees. Such short-term information cannot be incorporated efficiently if rebalancing happens only once or twice per year. In addition, daily portfolio management can further enhance investment outcomes by maintaining a consistent and accurate focus on the desired long-term drivers of expected returns and continuously balancing trade-offs between premiums, costs, and diversification.

Michael Beech CFA is an experienced investment specialist and is responsible for providing investment advice as well as managing the investment portfolios for many Alliotts clients. Click here to read more or call Alliotts in Auckland on 09 520 9200.

FOOTNOTES

  1. S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
  2. Stock return over the week prior to index addition is from Friday, December 14, 2020, to Friday, December 18, 2020. Stock return over the following week is from Friday, December 18, to Thursday, December 24. Data are from Bloomberg LP, compiled by Dimensional.
  3. Total assets indexed to S&P indices is from Annual Survey of Assets published by S&P Dow Jones Indices, as of December 31, 2019.
 

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