Tesla’s Charge Reveals Weak Points of Indexing
Index additions and deletions are typically a routine affair, but the recent announcement by S&P that Tesla would be added to the widely tracked S&P 500 Index stirred up quite a lot of attention. No surprise, given that Tesla is the largest company to ever join the index and, at the time of its addition on December 18, 2020, became the sixth-largest company in the S&P 500. On news of the announcement on November 16, Tesla’s stock price jumped 8.2% from $408.09 to $441.61. As shown in Exhibit 1, Tesla then continued to post strong returns, closing December 18 up 70.3% since the announcement. That made the 2.3% return to the S&P 500 Index1 over that period look meager by comparison.
Past performance is no guarantee of future results.
Notes: Stock price data from Bloomberg L.P. Time indicated is US Eastern time. Intraday price equal to (bid price plus ask price)/2, calculated by Dimensional using data from Refinitiv Tick History (TRTH).
What does this mean for investors? The answer, unsurprisingly, is that it depends.
Indices generally undergo regular reconstitution events during which securities are added or deleted. Index funds, constrained by the objective of maintaining low tracking error versus the index, generally have to mirror these changes by purchasing and selling securities based on the revised index weights. With over $4.6 trillion in assets tracking the S&P 500 as of year-end 2019, that implies many index funds sought to buy Tesla stock on the day it was officially added to the index.3
For passively managed index funds, this lack of flexibility can come at a cost. One way to assess this potential cost is to examine the extent to which index reconstitution events are associated with unusually high trading volume. Abnormally high trading volume is a potential indication that demanding immediacy to trade in such stocks in the same direction may be costly. We illustrate such abnormal trading volume in Exhibit 2, which compares trading volume in stocks added to or deleted from the S&P 500 on reconstitution day with trading volume in the same stock on days before and after the reconstitution day across reconstitution events over the 2015–2019 period. For the 40 days before and after reconstitution day, we present the average volume for rebalanced stocks as a multiple of the stocks’ volume on the day 40 days prior to reconstitution. If trading volume on reconstitution day is abnormally high for a rebalanced stock, it would lead to an increase in its multiple of volume traded on reconstitution day relative to non-reconstitution days. Indeed, averaging the volume ratios across all events over the five-year period, we find that trading volume for rebalanced stocks spikes more than 25 times relative to volume over the prior 40 days.4
Order of the Day
Abnormal Trading Volume in S&P 500 Index, 2015–2019
Demanding such unusually large trade volume can result in price pressure. But this price pressure does not have to manifest itself all on the day of reconstitution. At Dimensional, we believe market prices are forward-looking. Thus, because index rebalances are announced before the reconstitution date and often anticipated before the announcement date, an approach that is constrained to rebalance on the same day as an index may suffer from price pressure well ahead of the reconstitution date. Indeed, our research shows that stocks added to an index tend to outperform their respective indices prior to rebalancing, while stocks deleted from an index tend to underperform.
The remarkable upward march of Tesla’s stock price ahead of its addition to the S&P 500 is consistent with that pattern.
More broadly, we see in Exhibit 3 that the prices of additions (deletions) start to move higher (lower) than those of their index peers one month before the reconstitution day for the S&P 500.5 This behavior suggests pricing adjustments may be occurring well before the reconstitution day for those indices.
Average Cumulative Excess Return of S&P 500 Additions and Deletions, 2015–2019
S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
Stock return over the week prior to index addition is from Friday, December 14, 2020, to Friday, December 18, 2020. Stock return over the following week is from Friday, December 18, to Thursday, December 24. Data are from Bloomberg LP, compiled by Dimensional.
Total assets indexed to S&P indices is from Annual Survey of Assets published by S&P Dow Jones Indices, as of December 31, 2019.
Reconstitution events for S&P indices sometimes fall on triple-witching dates, or days on which stock index futures, stock index options, and stock options all expire simultaneously. We examine reconstitution events outside of normal rebalancing dates, and therefore on days that do not overlap with triple-witching dates, and find that stocks added to or deleted from the S&P 500 Index still experience, on average, trading volume 26 times greater on the date of rebalancing relative to the trading volume 40 days earlier.
The initial increase in the gray deletion line is primarily driven by ENSCO PLC, which was dropped from the S&P 500 Index on March 29, 2016, due to an international merger. See “Ensco plc and Rowan Companies plc Merge to Form Ensco Rowan plc, Industry-Leading Offshore Driller,” Business Wire, April 11, 2019.
This information should not be considered a recommendation to buy or sell a particular security. Named securities may be held in accounts managed by Dimensional. Indices are not available for direct investment.
The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd, Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
Equius Partners, Inc. is a Registered Investment Advisor.
Past performance is not a guarantee of future results. The data and information set forth herein are provided for educational purposes only and should not be considered tax, legal or investment advice; a solicitation to buy or sell securities; or an opinion on specific situations – as individual circumstances vary. There is no guarantee an investing strategy will be successful. Investing involves risks, including possible loss of principal. Diversification does not eliminate risk, including the risk of market or systemic loss.
Please consider the investment objectives, risks, and charges and expenses of any mutual fund and read the prospectus carefully before investing. Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
© 2023 Equius Partners, Inc.