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- Since news of Tesla’s December listing in the S&P 500 index broke Monday, the electric carmaker’s shares have risen more than 20% and gained more than $ 100 billion in market capitalization.
- Tesla’s mega entry into the major US large-cap index sheds light on how index fund managers tend to “buy high and sell low,” which is the focal point of a 2018 research article by the pioneer. in investments Rob Arnott.
- In an interview, Arnott explains how index additions tend to gain a lot before they are officially added, while deletions end up losing a lot up front, but the pattern reverses the year after these changes are implemented.
- As a result, it offers an “almost risk-free” arbitrage strategy that investors can take advantage of with a small portion of their portfolios.
- Visit the Business Insider home page for more stories.
Since S&P Dow Jones Indices announced Monday that Tesla will be added to the S&P 500 before the market opens on Dec. 21, the electric carmaker’s shares have risen more than 20% and recovered more than $ 100 billion. in market capitalization.
With a market cap of $ 418 billion as of Thursday morning, Tesla will be the largest stock to enter the major US large-cap index.
Tesla’s mega entry is good news for its shareholders and CEO Elon Musk, who is on his way to surpass Facebook CEO Mark Zuckerberg and become the third richest person in the world. But it poses a daunting task for index funds that had $ 11.2 trillion compared to the S&P 500 as of December 2019, according to S&P Dow Jones Indices.
Based on Tesla’s current market capitalization, the stock would enter the S&P, which has a total market capitalization of $ 30 trillion, weighing 1.4%. This means that index fund managers, whose goal is to track indices as closely as possible, would need to buy $ 157 billion worth of Tesla shares.
“What they have here is a huge pending purchase by what I would call valuation-indifferent buyers,” said Rob Arnott, founder and president of Research Affiliates, which advised on $ 145 billion in assets through September, in an interview. .
“Buyers who have to buy regardless of valuation and who will buy without any knowledge or concern about whether the shares are too expensive or too cheap,” he explained. “And the result is just a big reduction in the supply of that stock for those who have an opinion on the fair price, and a big increase in the proportion of that stock that is literally taken off the market and placed in non-tradable positions. within an index fund “.
On the other hand, the addition of Tesla also means the removal of a similarly sized stock from the index. While the index committee has yet to announce which stocks Tesla will replace, it would be difficult to find a stock that lives up to the Tesla scale. That means index fund managers will have to sell the other 499 shares of the S&P 500.
“Yes, presumably, they are going to remove a stock, and that stock, the ownership of the index fund will drop 100% to zero. But the other stocks in the index will also be cut by a small amount,” he said. Arnott. “That represents an immediate sell at the closing price typically the day the index change is effective.”
How Index Fund Managers ‘Buy High and Sell Low’
Routine rebalancing of the index has immense implications for investors due not only to the massive amount of assets that track the index, but also to a market phenomenon detailed in Arnott’s 2018 article ‘Buy High and Sell Low with Funds! indexed! ‘
In the paper, Arnott explains that index funds that track traditional market capitalization-weighted indices buy stocks with a high market valuation and sell stocks at a steep discount due to what happens between the time an addition is announced or elimination and when the change is really effective.
“When a stock is designated to be added on the announcement date, the stock shoots up to the effective date,” he said. “And the aftermath is that the stock has already peaked on or immediately after the effective date, and then it tends to fade a bit.”
The opposite can be said for stocks that will soon be phased out if it is a “discretionary dip”, meaning the index committee decides to delete the stock rather than simply delete it because it has ceased to exist due to actions such as mergers. and acquisitions and acquisitions.
“When a company is a discretionary elimination, it is inevitable because it has become so small and uninteresting that they are almost ashamed to have it on the index, so they eliminate it,” Arnott said. “The opposite is true there. On average, those stocks outperform the market by 20 percentage points over the next 12 months after they crash.”
As such, contrary to popular belief, Arnott thinks that index fund managers move stock prices indirectly.
“The price is moved by the hedge funds that are loaded into Tesla in anticipation of transferring it to the index funds on the date the addition becomes effective,” he explained.
An almost risk-free arbitrage opportunity
Arnott’s original paper also examines how index fund managers can position their portfolios by anticipating index additions and deletions or by trading three to 12 months after their peers to capture some of the “incremental alpha.”
However, he admits to having overlooked the fact that “the indexing community has made a very successful case in the minds of their clients that any tracking error relative to the index is a sign of incompetence.”
“So if it outperforms the index by 20 basis points a year, plus or minus 20. That looks like 20 basis points of volatility, slop, even if it’s always positive,” he said, recalling a conversation with the head of indexing for one. from leading index fund managers.
But not all investors have to meet the minimum tracking error mandate, which measures how closely a portfolio tracks the index it is being compared to.
For those who wish to take advantage of the arbitrage opportunity available for a small but almost risk-free alpha, Arnott offers a solution.
“One thing you can do is take a very small piece of your portfolio. And the day after a stock has been added to the index, and another stock has gone down, buy some of the stocks that fell,” he said. “Because on average it is over 20 percentage points over the next year, so wait and see what stocks fall.”
Arnott notes that the stocks to be removed may no longer exist due to some type of corporate action, but if it is an existing stock that is being removed, the forced sale of the index funds will create a buying opportunity.
“An investor who takes maybe 5% of their money and puts it in the stocks that went down,” he said, “two-thirds of the time, they’re going to win next year and the average margin of victory will be S&P plus 20%. . That’s great “.
