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Tesla and the soft dictatorship of the index

In my previous article I covered the issue of Tesla’s possible inclusion in the S&P 500, noting that having risen over 600% in the past year, index inclusion could send a new wall of money its way given the top three American ETFs would need to buy $6.5bn in Tesla stock alone.  Behind the retail ETFs also sits an immense amount of institutional money that lazily tracks the S&P 500.  What happens when they all need to make Tesla around 1% of their portfolios too?

Yet there is another angle we must consider with Tesla’s potential S&P 500 membership: active managers and the soft dictatorship of the index.

If Tesla becomes 1% of the S&P 500, then a vast amount of actively managed equity funds in America that are benchmarked to the S&P500 suddenly need to care about Tesla.  They may not like Tesla, or Elon Musk, or cars.  No matter.  Tesla is 1% of their benchmark.  If it doubles again (like it has roughly three times in the past year) and they weren’t holding it, this alone equates to 100bps of drag to their benchmark.

Suddenly, lots of active managers might need to own Tesla too, just so they’re not left behind.

This is all hypothetical, but it does delve into the nature of indices and their applications.

Equity market indices were devised as a way of measuring the markets.  Index returns, sector weights and other data described the performance and profiles of various parts of the equity markets both domestically and across borders.

This was all pretty unexceptional, until it was realised that replicating the benchmark into a real portfolio could be done very cheaply and getting market performance with low fees was a pretty good investment strategy.

So passive investing grew.  And grew…  so that there are now more indices than there are stocks and more than 7,000 ETFs globally.

Importantly, though, the biggest equity passive fund category is still broad market cap equities – the ASX S&P 200 or S&P 500 or FTSE 100 – and those benchmarks remain the key comparison for performance for most active managers.

So just like managers in the US with Tesla, Australian managers need to worry about momentum stocks like Afterpay, which is now a top 30 ASX company after rising by 850% since its lows in March/April.   Not owning it has put some benchmark drag on domestic portfolios, while if you buy an ASX200 ETF today your position in Afterpay is bigger than your position in Cochlear or Sydney Airport or the ASX itself.

None of this is to say benchmarking is kaput or passive investing is broken.  It’s more an observation that, once again, the act of measuring something itself has an effect on that thing that is being measured:  The equity markets began being measured by market cap indices, which then got turned into cheap equity portfolios, which then grew exceptionally quickly and began impacting the very markets the indices were designed to measure, both directly through passive fund flows and indirectly through managers being compared to that benchmark.

This second derivative effect on active managers is amplified by the tremendous flows of money going into passive funds which creates a strong momentum effect on their constituents, forcing many active managers to hold these stocks.

It’s not clear where this will all end up, but it is clear that we live under the soft dictatorship of the index.  They don’t just measure the market anymore.  They are the market.

They have metamorphosed from a spreadsheet into a neat portfolio and onto a colossus that are on track to surpass all other parts of the market, combined, in both fixed income and equities.

Diversification has therefore progressed from being about equities vs bonds or domestic vs international.  These are still important, but passive vs active has become a new tenet of portfolio diversification.  Active equity funds still live under the soft dictatorship of the index, but unlike passive funds they still have discretion about what price they will pay for a stock.  As passive continues its relentless growth, that discretion may prove valuable for active managers and something that passive funds, obediently following their index, wished they had.

At eInvest, we provide active ETFs where active management makes sense: equity income (EIGA), small cap equities (IMPQ) and fixed income (ECAS, ECOR, EMAX).

 

Disclaimer: Please note that these are the views of the writer, Tamas Calderwood, Distribution Specialist at eInvest and is not financial advice. 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.