Tesla’s inclusion in the S&P 500 next month is set to trigger a frenzy of trading, with Wall Street bracing itself for billions of dollars in shares to change hands when the stock enters the index.
The electric carmaker’s debut on the S&P 500 will be the biggest on record, instantly making Elon Musk’s company one of the largest weights on the blue-chip US stock index. A boom in passive investing — in which funds seek to reflect the performance of an index — has magnified the effect the move will have on the broader market, industry participants said.
Passive funds with $4.59tn in assets, such as those run by Vanguard and Fidelity, track the S&P 500, according to data compiled by Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. Tesla’s inclusion on the index would create some $51bn of demand for shares from these investment vehicles, he said.
Another $6.7tn in actively managed funds use the S&P 500 as their benchmark. Strategists with Goldman Sachs estimated that of the 189 large-cap funds they tracked, 157 with $500bn of assets in total did not own Tesla at the start of the fourth quarter. Analysts say these funds will add fervour to the buying of shares as they seek to rebalance their portfolios.
Tesla’s sheer size means the normally pedestrian index rebalancing process has become more complicated. Tesla’s free float, or the market value of shares available for trading, dwarfs Berkshire Hathaway and Facebook when they were added to the index, at $127bn and $90bn respectively, according to S&P Dow Jones Indices.
“Tesla is the largest company we have considered for inclusion in the S&P 500,” said Mr Silverblatt.
Trading houses, market makers and fund managers said they were expecting extraordinary volumes on December 18, the last trading day before Tesla formally joins the S&P 500. The date is typically busy for markets even without the Tesla addition since it is one of the last days for making big trades before markets slow down ahead of the winter holidays.
S&P is debating how to add Tesla to the index, given that the stock’s large weighting will also reduce the influence of the other 504 constituents. It may end up adding Tesla in two steps to slow down the process, it has said.
Market makers, which hold inventories of stocks in order to facilitate trading, are also pondering when to add to their holdings of Tesla shares as they balance expectations the stock will be highly volatile against what they see as assured demand. For big trading houses and brokers, it means large trading gains or losses are on the line.
“There is a long lag between [the] announcement and December 18,” said Chris Johnson, head of ETF markets at Charles Schwab, referring to S&P’s decision last week to add Tesla to the index. “That’s a long time to try to pre-position on a very volatile stock like this.”
Complicating matters for market makers and passive fund managers is how other investors are getting ahead of the impending inclusion, which has pushed the stock price higher. Tesla is up sixfold this year and traded above $500 a share on Monday. For market makers, hedging the risk of any decline in the carmaker’s price before its inclusion in the S&P 500 next month may prove tricky, traders said.
The composition of major equity benchmarks has become increasingly important in the past decade as investors have ploughed ever greater sums into passive funds. When companies are added or removed from a benchmark, exchange traded funds adjust their holdings in tandem, seeking to mirror the index as closely as possible at the lowest cost possible. They are judged on that basis by a metric known as tracking error, and minimising it is a top priority of passive fund managers.
“As an index provider we’re surgically focused on tracking error,” said Luke Oliver, head of index investing in the Americas at DWS, adding, “it will be all hands on deck” for “the entire market ecosystem around this”.
Typically when a stock is added to an index like the S&P 500, passive funds seek to buy as many shares as they can at the close of trading on the day before the addition to avoid tracking error. Market makers will often agree to guaranteed end-of-day trades. But Tesla’s size has complicated that plan. Some money managers are now debating buying Tesla stock before the 4pm New York close or on the following trading day, even though it could increase their tracking error.
Greg Sutton, head of equity portfolio trading at Citadel Securities, said the possibility of a two-step addition could “address fears of excess impact in Tesla as well as in some of the underlying S&P constituents”.
ETF providers had until last week to give feedback to S&P on the move, with a decision from the index provider on how to proceed expected by November 30. Whether it was split or done in a single shot, they said they did not expect any hiccups, regardless of what could shape up as a hectic close to the trading day.
“This is the largest trade for the S&P 500, but not the largest trade we have handled as a firm,” said Matthew Bartolini, head of SPDR Americas Research at SSGA.