Investors Front-Running Tesla Index Inclusion Had the Right Idea

(Bloomberg) -- It will be little consolation to investors who bet Tesla Inc. would be named part of America’s benchmark equity gauge by now, but the evidence says they had the right idea.

Market participants who buy or sell ahead of upcoming index changes can steal a significant advantage from the world’s growing army of passive funds, recent research has shown.

Index followers make changes when their underlying gauges do, and it means they end up paying more or accepting less to make any adjustments. This can create a huge performance drag for passive players, according to a paper from Solactive AG.

“Cost-conscious index investors should reckon with this impact,” researchers at the Germany-based index provider wrote. “The proverb, ‘the early bird catches the worm,’ is relevant in financial markets as well.”

Confirmation that preempting a stock’s addition to a major index can be hugely profitable will shock few on Wall Street. But a reminder of one of the clear advantages still enjoyed by active investors seems timely, since Tesla shares slumped after the carmaker’s failure to be included in the S&P 500.

In its paper, “Passive Investing and the Effects of Reconstitution,” Solactive drew on U.S. stock data between December 2002 and December 2019.

Using a simple model to measure the excess return of a hypothetical portfolio that reconstituted four weeks before of its underlying index, researchers found statistically significant impacts from moving ahead of the official changes across almost every month and size segment.

The results draw from and chime with earlier research by Rene Kuil at PGGM Investments, who showed funds tracking the MSCI Minimum Volatility World index that rebalanced on the same day as the gauge suffered a performance drag of 44 basis points compared with those which adjusted on the day changes were announced.

In the case of the Solactive research, there are obvious catches. Investors need to act in a timely fashion, or the advantages erode. And they need to make the right call.

The paper assumes the hypothetical portfolio can predict the upcoming changes in the index with 100% accuracy -- something many Tesla shareholders would argue is easier said than done.

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