Tesla Going in S&P 500 Is What the Smart-Beta Geeks Warned About

(Bloomberg) -- Concerned that Tesla Inc. may prove to be a drag on the S&P 500 when it enters the index after such a gigantic rally? You’re not alone. There’s a group of Wall Street data nerds who have been making a similar case against traditional stock benchmarks for years.

Some of them are quants who fly the flag of “smart beta,” that hybrid of active and passive management that holds among other things that indexes weighted by market value suffer by chaining their fortunes to big and bloated companies. Tesla’s imminent entry into the S&P 500 is stirring their passions by framing the debate in particularly stark terms.

Pioneers such as Rob Arnott are making the rounds and publishing studies in the run-up, trumpeting data that purports to show that megacap companies have the potential to harm passive returns. The view accords with the smart-beta ethos that says many stock indexes stumble when the massive companies that dominate them run out of room to grow.

To illustrate the drag, Arnott and a colleague at Research Affiliates wrote a paper titled “Tesla -- The Largest-Cap Stock Ever to Enter S&P 500: A Buy Signal or a Bubble?” Looking at 31 years of data, they found that when a company is big enough to enter the index as one of its 100 largest members, it falls 7% over the following year, on average. Meanwhile, the average deleted company beats the gauge by 20% after being kicked out.

It’s evidence that benchmark overseers such as S&P Dow Jones Indices “buy high and sell low,” resulting in a performance gap of 24% between megacap entrants and discretionary deletions over the next 12 months, according to the paper. That ultimately costs investors money, and exposes what quants such as Arnott consider a fundamental flaw of market-cap indexes -- too much dependence on companies whose best days may be behind them.

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

Elon Musk’s electric-car maker has soared almost ninefold from the depths of March, when the coronavirus sent shockwaves through global financial markets. A lot of those gains can be chalked up to investors anticipating that Tesla would be added to the S&P 500, given that the company’s profits and production levels have been “utterly mundane” this year, Arnott said. The shares have surged more than 50% since mid-November, when S&P Dow Jones Indices said it would add the company the following month.

You don’t need to be a smart-beta theoretician to take issue with the handling of Tesla. In a note titled “Time to Fire the S&P 500 Index Committee,” Vincent Deluard, a strategist at StoneX, wrote this week that waiting around to add Tesla cost index investors more than $500 billion and “transferred retirement savings to speculators.”

To be sure, any critique of index investing risks sounding misplaced at this point in the market cycle -- a year in which the S&P 500 has managed an almost 15% rally and left the vast majority of active funds in the dust. Arnott and his smart-beta acolytes are aware of the perception, conceding that conventional indexes do well against many backdrops. Their criticism focuses more on longer-time lines, claiming that it is over those that the handicaps embedded in cap-weighted indexes show up.

Historically, one of their answers has been to build indexes that strip out market-value biases -- gauges in which a titan like Tesla is given the same weight as a relatively tiny stock such as Under Armour Inc. Atop those, they layer in screens to focus indexes on companies that, say, pay the highest dividends or trade cheapest to earnings. But at the core of the philosophy is a belief that standard-investing benchmarks are weighed down by just the sort of rules that cause S&P to add Tesla after its market cap swelled by $500 billion in a year.

The addition of the company -- currently trading at 20 times sales or almost 10 times the S&P 500’s valuation -- is expected to spark billions of dollars in purchases from the estimated $4.5 trillion worth of funds that track the index. That demand will be squeezed into an “artificially short time-frame” and further distort prices, given that the funds that benchmark to the index need to make adjustments on the effective date, according to Dimensional Fund Advisors, which has owned Tesla in its funds for the past nine years.

“The goal of an index fund manager is not to increase expected returns for the shareholders, it’s to minimize tracking error,” said Wes Crill, a senior researcher at the quant giant, which oversees $527 billion. “There is a cost to investors that is in some ways almost arbitrary because they’re being told what to do and when to do it based on an index, and not so much their own assessment of the characteristics of that company.”

While market cap-weighted indexes aren’t necessarily flawed by design, investors would be better served by staying away from the fray, Crill said. Arnott agrees. While it’s a “very dangerous game” to bet against Tesla, investors could simply choose not to own it, he said. And looking at over 30 years of S&P 500 history, the best time to sell Tesla would be on the day after its entry. On the other side of the trade, buying shares of Apartment Investment and Management Co. -- set to exit the index to make way for the vehicle maker -- may prove lucrative.

“When people say, ‘When is the Tesla bubble going to burst?’ I’ve jokingly said on the 22nd of December,” Arnott noted. “Nobody knows, but that’s when the index addition argument disappears and that’s when the market starts to search out what the company’s really worth.”

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