Tesla Inc’s S&P 500 Inclusion is Set to Become the Biggest Test For Passive Investors

Passive, or indexed, investing has been on an exponential rise this century as technology has driven down costs for both institutions and retail

Ryan Bushell | December 17, 2020 | SmallCapPower:  It is unlikely that I need to update readers on Tesla Inc’s (NASDAQ:TSLA) meteoric rise in the last 12 months. On December 21st Tesla will finally be added to the S&P 500 as the 6th largest company in the index at a market capitalization of over $600 billion, just behind Amazon and Facebook and just ahead of Visa and Berkshire Hathaway.

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Promoters of the stock, led by visionary CEO Elon Musk, claim that Tesla is on the verge of benefitting from the “platform effect,” whereby a technological platform gains critical mass, then its user base inflects substantially higher. Microsoft, Google, Facebook and Amazon have benefitted from the platform effect in the past few decades. Detractors of the stock, including myself, point out that Tesla is not a technology company with low variable costs per user. Google doesn’t have to build a new Google for every user, in fact every user makes Google more valuable from an advertising perspective.  Tesla, on the other hand, must build a new Tesla for each user they attract. Where Google benefits from the hyper economics of a true technology platform, Tesla must deal with the traditional economics of a manufacturer trying to scale a new process of manufacturing cars in an already intensely competitive, low-margin business.  So far Tesla has benefitted from manufacturing a high-quality product, but that may change as they try to scale up operations in multiple jurisdictions and secure a novel supply chain including battery materials.

While the debate above is certainly interesting, it’s not the subject of my attention here. The addition of Tesla at such a large (and possibly inflated weight) to the most tracked benchmark in the world is set to test the validity of passive investing theory. Passive (or Indexed) investing has been on an exponential rise this century as technology has driven down costs for both institutions and retail. The theory behind passive investing is that the index is the sum of all decisions made by active (non-indexed) investors and thus represents more knowledge than any one participant could possess. The index essentially freeloads off the work of individuals trying to maximize returns from their individual portfolios. This works well when you have many active (non-indexed) participants relative to few passive (indexed) participants.  Today, however, passive investors represent nearly half of all fund assets invested in the United States and are on the rise around the world as well.  As the influence of passive investors has grown ever larger it has created a tail wagging the dog effect, whereby active investors now look over their shoulder at the index when making their decisions as their compensation depends on favourable measurement versus the index on a relative and short-term basis.

In the 2010s, technology stocks benefitted from a self reinforcing cycle of USD accumulation by the world financed by the ever-expanding US trade deficit.  As dollars were accumulated in 2009-12 following the first round of exceptional money printing, they had to go somewhere but Treasury Yields were held down by the Fed so increasingly equities were the vehicle of choice. Then the US economy started to lead us out of the recession and technology stocks were the leaders of the leaders, so they attracted the most capital. This increased weightings in the index, which brought on more buying due to the dramatic shift toward passive (indexed) investing since the mid 2000s. To keep up with passive benchmarks (again indexes) active managers have been forced into owning more technology stocks, which created more weight in the index, which spurs more passive buying and so on.

Clearly the key thesis behind passive investing (the wisdom of crowds) was set to be tested as the crowd thinned dramatically last decade. Tesla could be that test. The worst case for indexed investors is a company with a tremendous amount of hype (and market capitalization) relative to profit gets put into the index after a several hundred percent rise just before it collapses taking a good-sized chunk of the index and its freeloading investors’ capital with it. We already know the index committee is worried about this prospect given their erratic behaviour surrounding the index inclusion, first denying Tesla’s inclusion early September, then announcing that Tesla would be added in two tranches during December before ultimately reversing that decision as well and sticking to a single tranche addition on December 21st.  The shares dropped by 1/3 following the decline announcement in September before rallying almost 100% into the December index inclusion.  Obviously, the index decision is influencing price discovery in a big way.

Whatever your view is on passive investing broadly, or Tesla specifically, the results of this test will be fascinating. Nothing in this world is free, the 2020s could be the decade where passive investors get what they pay for. My Newhaven clients and I will be firmly on the sidelines watching this battle play out.  We’ll be munching on popcorn, paid for with the dividends we collect on our boring dividend stocks.

Ryan Bushell is President and Portfolio Manager of Newhaven Asset Management Inc., where he focuses on meeting the needs of his individual clients. He has been a regular guest on several BNN Bloomberg programs, including Market Call, since 2011 and is a frequent contributor to the Globe and Mail, Toronto Star, Reuters and Bloomberg. He can be reached at rbushell@newhavenam.com

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