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    Bubble, Double and Passive Indexing Trouble…

     

    “Tesla’s addition to the index (S&P500) is expected to be particularly challenging because the company will be the largest to ever join, and it is expected to make up at least 1% of the gauge”.

    The Wall Street Journal (emphasis added)

    That the WSJ refers to the S&P 500 index as a gauge is, to say the least, an anachronism.  The S&P 500 went from being a gauge to becoming the world’s most titanic equity portfolio many, many years ago as passive investing powered away, and I use “titanic” symbolically.

    Tesla is slated for inclusion in the S&P 500 index on December 21st.  At least US$5 trillion tracks the index passively, meaning passive funds will be required to buy around US$50bn of Tesla stock for their portfolios, a figure recently confirmed to the Financial Times by S&P.

    Tesla’s stock price has doubled more than three times this year.  It is up over 600% year to date and over 50% this month.  It is by far the world’s most valuable automaker, with a market cap of US$540bn – more than the next 6 largest automakers combined.  Not bad for producing just 0.4% of the world’s annual fleet.

    Tesla is not the only electric vehicle stock that has been surging.  Others like Nikola, XPeng, Li Auto, NIO and Arrival Ltd have also seen their share prices surge, so investors are clearly eager to send capital towards the electric vehicle sector.

    What is different about Tesla is its scale and the side-effect this will have on the benchmark that was originally designed as a measuring gauge.  The electric vehicle bubble’s approaching collision with a wall of passive money will test just what an index like the S&P 500 is these days:  a gauge that measures the market, or the piper guiding the largest financial herd in history?

    When Yahoo joined the S&P500 in 1999, its shares surged over 60% in the days leading up to its inclusion.  Verizon bought Yahoo in 2017 and the stock was removed from the index approximately 75% below its price on its announced S&P 500 membership.  In effect, the index gained exposure to Yahoo at the top and got out at a big loss.

    If the index were merely a gauge, this “loss” would be purely academic and unrelated to the stock’s inclusion in the index.  The index includes the stock based on its size and deletes it when delisted.  The stock’s movement throughout its index membership contributes to the index performance and sector weights during this time.  In theory, the measurement of the stock has no effect on its performance.  Yahoo was just a glitch.

    Since that glitch, passive investing has seen the “gauge” morph into the world’s biggest equity portfolio, exactly replicated by hundreds of managers with trillions of dollars spread throughout the world.  Money flowing into these portfolios buys whatever is in the “gauge” (the S&P500 index), regardless of price.  The gauge is therefore attracting money into the stocks it measures, which pushes up the value of those stocks, which may attract more investors to index funds tracking those stocks, which increases the measurement reading of the “gauge”, which… well, you see the circularity here.

    So, mark down December 21, 2020 as a date to watch.  Tesla’s inclusion in the S&P500 will create a wave of non-discretionary demand for the stock and the effect on Tesla’s share price will be of great interest.  Of greater interest will be the effect it has on the S&P 500 and passive investing.

    Can active management avoid the distortions of index enslavement?  Will the passive juggernaut roll on regardless?  Or will Tesla’s adventure into the S&P 500 send up a flare about the dangers of passive investing?

    My recent series of articles on Tesla and my podcast with Phil Muscatello from Shares for Beginners argue that passive investing is now approaching a scale, particularly in the US, that will lead to unknowable and funky outcomes.  When at least US$5trillion in investments follows every trade and rebalance of a single index we are looking at unparalleled herd behaviour in the financial markets.  This version of capital allocation is unthinking and automatic, determined only by a stock’s weight in the mother of all indices.  Tesla is the case study that everyone is watching to see how it plays out.  Those outside the herd – active managers – can sit by and watch it all unfold, but we will all be affected.  The massive passive experiment is facing another, bigger glitch.  BZzzzt….

    eInvest is launching active ETFs where we believe active management makes sense:  equity income, small caps and fixed income.

    Disclaimer: Please note that these are the views of the writer, Tamas Calderwood, Distribution Specialist at eInvest and is not financial advice. The writer also holds an S&P500 ETF. To find out how to invest in our active ETFs, visit here. The product disclosure statement and more can be found at www.einvest.com.au. If you’d like to keep learning further, please feel free to follow any of our socials listed below.