Tesla Joins the S&P500 Index. What You Need to Know.

On December 21, 2020 Tesla (TSLA) became the largest stock, measured by market capitalization, ever added to the Standard & Poor’s 500 Index. This change automatically created massive new demand for the electric vehicle maker’s stock, since index funds based on the S&P 500 must now own it. Helped by investors’ anticipation of the event, TLSA soared by 22% between November 30, when S&P announced its decision to add the stock to the index, and Friday, December 18. The S&P 500’s rise over the same period was just 2%.

Why Tesla’s addition to the index was controversial

The S&P 500 and its sector-defined subindexes form the basis for a substantial portion of passive index funds that now own about half of the U.S stock market. Ironically, the S&P 500 index itself is in a sense an actively managed portfolio. The stocks that compose it are not fixed over time. Moreover, the committee at Standard and Poor's ("S&P") that adds and removes stocks necessarily makes some judgment calls. Unlike active fund managers, though, the S&P decision makers do not seek to maximize the risk-adjusted return of their “portfolio.”

To qualify for admittance to the S&P 500, a stock must meet specific standards:

• Market capitalization of at least $8.2 billion

• Headquarters in the U.S.

• Annual trading volume at least as great as company’s market capitalization

• Trading volume of at least 250,000 shares in each of the previous six months

• Most of company’s shares in the public’s hands

• At least one year elapsed since initial public offering

• Positive earnings in most recent quarter and in aggregate for previous four quarters.

Subjectivity enters the picture when more companies qualify than there are spots available. In Tesla’s case, Standard & Poor’s selection committee had several special factors to consider.

True, Tesla qualified for inclusion according to the standards listed above. Indeed, S&P took some criticism for not having long since added it to the index. The company IPO’d way back in 2010. By the time TSLA finally joined the index, its market capitalization was larger than all but four incumbent S&P 500 companies (counting all Alphabet share classes as one company).

On the other hand, there were qualitative arguments for opposing TSLA’s candidacy. To begin with, the company had not attained the requisite positive earnings through its core operations. TSLA posted four consecutive quarters of profitability only with the help of sales of zero-emission vehicle (ZEV) and other regulatory credits.

TSLA’s extreme volatility was another concern. For example, its price change measured +131% during July-August 2020 and -34% over just the next five trading sessions. Bloomberg calculated that TSLA was 60% more volatile than the S&P 500 over the previous five years and almost 90% more volatile during 2020. With TSLA ultimately accounting for 1.69% of the index’s market capitalization (versus 0.08% for the median constituent stock), buyers of index funds faced the possibility of amplified price swings due to the electric vehicles producer’s entry. However, research by Anna Pavlova of the London Business School (indicating that stocks tend to become less volatile after they join the S&P 500 index) mitigates these concerns.

How investors are affected

The S&P 500’s addition of auto-industry disrupter Tesla occurred against a backdrop of a longer-run transformation of the index. Historically, the S&P 500 was considered a broad proxy for large-cap stocks, highlighted by mature titans of American industry. The NASDAQ Composite was more dominated by young and dynamic, but risky technology names. But in late August, when the S&P 500’s rebound from the COVID-19 selloff propelled it to a new all-time high, the index excluding just six stocks—Alphabet, Amazon, Facebook, Microsoft, and Netflix—was around -4% on the year. The six supercharged names were collectively up by 43%.

Both passive investors in the S&P 500 and investors in actively managed funds that are benchmarked against it need to be aware of this change in the nature of the beast. Any faltering by the handful of dominant stocks will open up outperformance opportunities for active managers who do not hug the benchmark.