Tesla goes into S&P 500 is what the Smart-Beta Geeks warned about

(Bloomberg) – Concerned that Tesla Inc. could prove to be a drag on the S&P 500 when it hits the index after such a massive rally? You are not alone. There is a group of data nerds on Wall Street who have had a similar case against traditional stock benchmarks for years.

Some of them are quants that fly the flag of ‘smart beta’, that hybrid of active and passive management that maintains, among other things, that market value weighted indexes suffer by pegging their fortunes to large and inflated companies. Tesla’s imminent entry into the S&P 500 sparks their passions by framing the debate in particularly grim terms.

Pioneers like Rob Arnott are making the rounds, publishing studies ahead of time, trumpeting data claiming that megacap companies have the potential to hurt passive returns. The vision is in line with the smart beta ethos that says many stock indices stumble when the massive companies they dominate run out of room to grow.

To illustrate the barrier, Arnott and a colleague at Research Affiliates wrote a paper entitled “Tesla – The Largest-Cap Stock Ever to Enter S&P 500: A Buy Signal or a Bubble?” Looking at the 31-year data, they found that when a company is big enough to get in the index as one of the 100 largest members, it drops an average of 7% the following year. Meanwhile, the average company removed beats the meter by 20% after throwing it out.

It is evidence that benchmark regulators such as S&P Dow Jones Indices are “buying high and selling low,” resulting in a 24% performance gap between mega-cap entrants and discretionary deletions over the next 12 months, the paper said. That ultimately costs investors money, exposing what quants like Arnott see as a fundamental flaw of market cap indexes – an over-reliance on companies whose best days are behind them.

“This Tesla addition is a great illustration of that,” Arnott said in a telephone interview. “It’s up 800% from the March lows. Now you want to add it? “

Elon Musk’s electric carmaker is up nearly nine-fold from the depths of March, when the coronavirus sent shockwaves through global financial markets. Many of those gains can be attributed to investors expecting Tesla to be added to the S&P 500, as the company’s profits and production levels have been “utterly mundane” this year, Arnott said. Shares are up more than 50% since mid-November, when S&P Dow Jones Indices said the company would be added the following month.

You don’t have to be a smart beta theorist to tackle Tesla dealing. In a note titled “Time to Fire the S&P 500 Index Committee,” Vincent Deluard, a strategist at StoneX, wrote this week that he was waiting to add more than $ 500 billion of Tesla investors to the cost index and “save for retirement. handed over to speculators “.

Certainly any criticism of index investing threatens to sound out of place at this point in the market cycle – a year when the S&P 500 rallied nearly 15%, leaving the vast majority of active funds in the dust. Arnott and his smart beta acolytes are aware of the perception and admit that conventional indexes do well against many backgrounds. Their criticisms focus more on longer time lines, claiming that the handicaps embedded in cap-weighted indexes are above those.

Historically, one of their answers has been to build indexes that dispel the market value bias – meters in which a titan like Tesla is given the same weight as a relatively small stock like Under Armor Inc. to target indices at companies that, for example, pay the highest dividends or trade the cheapest relative to earnings. But at the heart of the philosophy is the belief that standard investment benchmarks are weighed down by the kind of rules that cause S&P to add Tesla after its market cap has surged $ 500 billion in a year.

The addition of the company – which is currently trading at 20 times revenue or nearly 10 times the S&P 500 valuation – is expected to make billions of dollars in purchases from the estimated $ 4.5 trillion in funds that track the index. That demand will be squeezed into an “ artificially short timeframe ” and further distort prices as the funds benchmarking for the index will have to make adjustments on the effective date, said Dimensional Fund Advisors, which Tesla has held in its funds. for the past nine years.

“The goal of an index fund manager is not to increase expected returns for shareholders, but to minimize tracking error,” said Wes Crill, a senior researcher at the quantitative giant who oversees $ 527 billion. “There are costs to investors that are in some ways almost arbitrary, as they are told what to do and when to do it based on an index, rather than their own assessment of that company’s characteristics.”

While market-cap-weighted indices aren’t necessarily flawed in design, staying away from the fray would serve investors better, Crill said. Arnott agrees. While betting against Tesla is a “very dangerous game”, investors can simply choose not to own it, he said. And looking at over 30 years of the S&P 500’s history, the best time to sell Tesla would be the day after its launch. On the other side of the trade, buying shares of Apartment Investment and Management Co. – which will leave the index to make way for the car manufacturer – be lucrative.

“When people say, ‘When is the Tesla bubble going to burst?’ I jokingly said on December 22, “Arnott noted.” No one knows, but then the index addition argument disappears and the market begins to look for what the company is really worth. “

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