Investing pioneer Rob Arnott told us a near risk-free strategy for investors to win big from Tesla joining the S&P 500 — and explained how the company's inclusion will lead index fund managers to 'buy high and sell low'
- Since news of Tesla's December inclusion into the S&P 500 index came out on Monday, the electric-car maker's stock has surged over 20% and picked up more than $100 billion in market cap.
- Tesla's mega entrance into the premier US large-cap index sheds light on how index fund managers tend to "buy high and sell low," which is the focal point of a 2018 research paper by investing pioneer Rob Arnott.
- In an interview, Arnott explains how additions to the index tend to win big before they are officially added while deletions end to lose big in advance, but the pattern reverses the year after these changes are implemented.
- As a result, he offers a "near risk-free" arbitrage strategy that investors can take advantage of with a small part of their portfolios.
- Visit Business Insider's homepage for more stories.
Since S&P Dow Jones Indices announced on Monday that Tesla will be added to the S&P 500 prior to the market open on December 21, the electric-car maker's stock has surged more than 20% and picked up over $100 billion in market cap.
With a market cap of $418 billion as of Thursday morning, Tesla will be the largest stock ever to enter the premier US large-cap index.
Tesla's mega entrance is all good news for its shareholders and chief executive Elon Musk, who is on track to surpass Facebook CEO Mark Zuckerberg and become the world's third-richest person. But it poses a daunting task for the index funds that had $11.2 trillion benchmarked to the S&P 500 as of December 2019, according to S&P Dow Jones Indices.
Based on Tesla's current market cap, the stock would come into the S&P, which has a $30 trillion overall market cap, at a 1.4% weight. This means that index fund managers, whose goal is to track the indices as closely as possible, would need to purchase about $157 billion worth of Tesla shares.
"What you have here is an enormous purchase pending by what I would call valuation-indifferent buyers," said Rob Arnott, founder and chairman of Research Affiliates, which advised on $145 billion in assets as of September, in an interview.
"Buyers who have to buy regardless of the valuation and who will buy without any awareness or any care about whether the stock is too expensive or too cheap," he explained. "And the result is just a large reduction in the supply of that stock to those who have a view on the fair price, and a large increase in the proportion of that stock that's literally taken out of the market and put into non-trading positions within an index fund."
On the flip side of that, Tesla's addition also means the deletion of a stock of similar size from the index. While the index committee has yet to announce which stock Tesla will replace, it would be hard-pressed to find a stock that measures up to Tesla's scale. That means the index fund managers will have to sell across the other 499 stocks in the S&P 500.
"Yes they are going to take one stock out, presumably, and that stock, the index fund ownership will fall by 100% to zero. But the other stocks in the index are also all going to be trimmed by a small amount," said Arnott. "That represents an immediate sale at typically the closing price on the day that the change in the index is effective."
How index fund managers 'buy high and sell low'
The routine index rebalance has immense implications for investors because of not only the massive amount of assets tracking the index, but also a market phenomenon detailed in Arnott's 2018 paper 'Buy High and Sell Low with Index Funds!'
In the paper, Arnott explains that index funds tracking traditional market cap-weighted indices routinely buy stocks at a high market valuation and sell stocks at a deep discount due to what takes place between when an addition or deletion is announced and when the change is actually effective.
"When a stock is designated to be added on the announcement date, the stock goes on an absolute tear until the effective date," he said. "And the aftermath is that the stock has already hit its peak either at or immediately after the effective date, and then tends to fade a bit."
The opposite can be said of the soon-to-be-dropped stock if it is a "discretionary drop," which means that the index committee decides to delete the stock instead of simply dropping the stock because it has ceased to exist due to corporate actions such as mergers and acquisitions, and takeovers.
"When a company is a discretionary deletion, it's inevitable because it's gotten so small and uninteresting that they're almost embarrassed to have it in the index, so they take it out," Arnott said. "The opposite happens there. On average, those stocks outperform the market by 20 percentage points over the next 12 months after they've been dropped."
As such, contrary to popular belief, Arnott thinks that index fund managers do move share prices indirectly.
"The price is moved by the hedge funds that load up on Tesla in anticipation of flipping it to the index funds on the date that the addition becomes effective," he explained.
A near risk-free arbitrage opportunity
Arnott's original paper also examines how index fund managers can position their portfolios by either anticipating the index additions and deletions or by making their trades three to 12 months after their peers to capture some of the "incremental alpha."
However, he admits overlooking the fact that the "indexing community has made a very successful case in the minds of their customers that any tracking error relative to the index is a sign of incompetence."
"So if you beat the index by 20 basis points a year, plus or minus 20. That's viewed as 20 basis points of volatility, sloppiness, even if it's always positive," he said, recalling a conversation with the head of indexing for one of the major index fund managers.
But not all investors have to abide by the mandate of minimal tracking error, which measures how closely a portfolio follows the index to which it is benchmarked.
For those who would like to take advantage of the arbitrage opportunity that's available for a near risk-free but small alpha, Arnott offers a solution.
"One thing you can do is take a very small part of your portfolio. And the day after a stock has been added to the index, and another stock dropped, buy some of the stock that was dropped," he said. "Because on average it outperforms by 20 percentage points over the next year, so wait and see what stock gets dropped."
Arnott notes that the stock that will get dropped may no longer exist because of some type of corporate action, but if it's a stock that exists that is dropped, the forced selling from index funds will create a buying opportunity.
"An investor who takes maybe 5% of their money and just puts it in the stock that got dropped," he said, "two-thirds of the time, they're going to win over the next year, and the average margin of victory is going to be S&P plus 20%. That's pretty cool."
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