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Did Tesla Just Make the S&P 500 Irrelevant?

A tool to track the investible market should probably include the market's biggest stocks.

Tesla  (TSLA) - Get Tesla Inc Report got snubbed.

Earlier this month, S&P Dow Jones Indices, the company that owns the S&P 500 index undefined and picks its components, opted to add three smaller names to the index as part of its quarterly rebalancing act.

Despite meeting the S&P’s profitability requirements, Tesla, the eighth-largest publicly-traded U.S. stock, didn’t make the cut.

Not yet, anyway.

But the decision begs the question: did Tesla just make the S&P 500 irrelevant?

If a stock market index is designed to represent the total investable market, not including one of the ten largest publicly traded equities probably isn’t a good sign.

It certainly hasn’t helped performance.

The S&P 500 would be almost 4% higher right now if Tesla were part of the index at the start of the year.

Most likely, volatility and position weight concerns played a role in S&P’s decision not to include Tesla in the index. With around a 1.1% theoretical weight in the index coming into this month, index funds alone would need to buy almost $50 billion in Tesla stock just to meet their allocation mandates.

The committee was probably hoping for valuations to cool off a bit before they added Tesla to the index.

Of course, that comes with risks of its own – like what happens if Tesla winds up even higher a quarter from now?

The longer Tesla remains excluded from the S&P 500, the less relevant the index becomes as a measure of “the market”.

Part of the issue is that subjective index rules don’t add a lot of value.

Over the last decade, the index hasn’t shown meaningfully different returns than a simple, cap-weighted index of the largest 500 U.S. stocks:

SPX_vs_500_largest

In fact, they’re perfectly correlated.

Again, that's not surprising -- they're almost the same thing. But then what's the value-add of the official index?

Why apply subjective discretion to factors like earnings quality, when the data above suggest that market participants are already discounting those factors for you?

Within the last year, we’ve seen a clustering of active positive returns from the biggest 500 stocks over the S&P:

SPX_vs_500_largest_2020

Part of that is because the S&P 500 is really, at its core, a trend following strategy – it allocates to stocks that are working, and reduces stocks that aren’t. That’s part of why it’s so hard to consistently beat the S&P over the long-run.

Exclude one of the biggest examples of “what’s working” in this market, and the S&P can’t perform as well – or reflect the U.S. market as accurately.

There are certainly good reasons for the S&P committee to be wary about adding a name as large as Tesla to their index right now. The sheer weight of the position would be almost unprecedented.

But the risks of not adding Tesla might be bigger.