Normally the process of adding a company to the S&P 500 is pretty straightforward. One company enters, another leaves. But as with so much else surrounding Elon Musk’s cutting-edge carmaker, with Tesla Inc. it’s complicated.
At almost $390 billion in value, Tesla would be the biggest company ever added to the benchmark. Pushing it all in at once would force index-tracking funds into serious contortions — they’d need to sell upwards of $40 billion of shares in other constituents to make room, by some estimates. As a result, the index’s overseer, S&P Dow Jones Indices, is considering doing it in stages.
After months of speculation that contributed to a near-quintupling in the shares, S&P Dow Jones said Monday the 17-year-old company would be added to the gauge in December. The committee is seeking feedback from the investors on whether to add it in two separate pieces, an unprecedented step. The company Tesla replaces will be named later.
“It wasn’t easy to make such an important decision, and this decision has a big impact,” said Howard Silverblatt, senior index analyst at S&P Dow Jones. (Silverblatt isn’t a member of the S&P 500 committee and isn’t associated directly with the decision to put in Tesla). “An open-ended dialog with investors will only help. You can’t put a company in at such a high level just like you would any other firm. The times have changed, the magnitude of the stocks that are being added has changed, too.”
News Tesla will enter the index, which drove its shares up more than 13% after hours partly in anticipation of demand from index trackers, ends one drama and starts a second. Besides boosting the uncomfortably large influence of technology companies in the biggest equity gauge, it starts what could be a frantic process among Wall Street’s sprawling passive investment machine to accommodate its addition.
About $11 trillion of investment assets are either tied or benchmarked to the S&P 500.
Given its heft, Tesla would likely be among the top 10 largest stocks in the S&P 500, falling somewhere between Johnson & Johnson and Procter & Gamble Co., with a weighting of more than 1%. That would equal the combined value of the 60 smallest stocks in the benchmark. S&P Dow Jones uses float-adjusted market-cap rather than the straight figure to apportion influence.
Usually when the S&P 500 is reshuffled, it occurs when a company is acquired or as part of a routine quarterly rebalancing. Often, changes happen due to shifts in a company’s size: one might be sent to the S&P’s small-cap or mid-cap indexes while another moves up to the large-cap gauge.
In October, industrial tech firm Vontier Corp. replaced Noble Energy Inc., which was acquired by Chevron Corp. Noble Energy last traded with a market value of $4.1 billion, not far off from Vontier’s $4.9 billion. E*Trade Financial, which was purchased by Morgan Stanley, was replaced by Pool Corp., a distributor of swimming pool supplies of roughly the same size.
In Tesla’s case, as far as index-trackers are concerned, there’s no single company large enough that its removal would offset its addition. Index-fund managers have speculated in the past that when the carmaker is added, they’ll need to sell small bits of other members of the gauge to create space.
“In effect, this is trading a pawn on the chessboard for a queen,” Lawrence Creatura, a portfolio manager at PRSPCTV Capital LLC, said by phone. “The size of Tesla as it’s being included in the index is much larger relative to the company that is likely to come out. That’s going to create a lot of shuffling among passive funds that track the S&P 500 explicitly.”
Given the sheer amount of investment dollars that track the benchmark, index mutual funds and exchange-traded funds were already hashing out strategies back in July for this possibility. Back then, when Tesla’s market-cap stood near $280 billion, Vanguard Group Inc. estimated managers of passive funds will have to sell about $35 billion to $40 billion of shares in the rest of the index’s companies to make a hole big enough to fit purchases of Tesla shares. Now, after over another $100 billion in value was added to Tesla, that amount is presumably larger.
Tesla’s path to the S&P 500 has been unconventional. Investors believed in Musk’s firm’s growth story enough to bid the share price ever higher despite a record dotted with more quarterly losses than profits. One rule for index inclusion requires that the sum of total earnings over the past four quarters must be positive — a feat Tesla did not reach until this summer.
As S&P Dow Jones’ Silverblatt said, “the times have changed.” Companies go public when they’re older now, once they have already delivered solid growth. This may be the first time passive index overlords and fund managers have to deal with such an untraditional addition. But it may not be the last.