By James Mackintosh
Aficionados of Tesla Inc. were celebrating last week as the
electric-car maker was accepted into the S&P 500, propelling
its shares up 22% in two days.
Step back from the extraordinary gains, and the fact that
America's seventh-biggest company by market value is only now to be
admitted to the index of the country's 500 most-valuable stocks is
weird. But it is only the most obvious of many strange but
stock-price-moving ways that indexes rumble markets. Indexes play
two important but often conflicting roles: They measure broad
market performance, and they are investment tools.
Start with Tesla. It will join the S&P 500 next month after
a decision by the committee that oversees the index. The same
committee had rejected the company in September even after it
finally met the index's qualification condition of being profitable
for 12 months.
Index membership really matters, because there is about $11
trillion benchmarked to the S&P, according to the company.
Passive funds will have to buy tens of billions of dollars of Tesla
stock -- hence, the big move in price. So much money will need to
move when the index is reconstituted next month that S&P is
consulting on adding the car maker in two chunks.
Again, for both the passive investor and those using the index
as a gauge of market performance, this is strange. Why do companies
have to be profitable before they are allowed into the index? The
whole point of investing passively is to leave it up to other
people to decide if a company earns enough to justify its stock
price. A gauge of performance should measure the profitable and the
loss-makers alike. Plenty of companies are loss-making after they
join the index, especially this year; it is odd that once in the
club, the condition no longer applies.
David Blitzer, who retired as chairman of the S&P index
committee last year, says the profitability rule was introduced
around 2000 as dot-coms boomed, because a previous "going-concern"
condition was seen as too vague.
Other than the profits rule, the fundamentals of a stock were
almost completely ignored by the committee. Almost. "The only time
valuations came up is if a stock had a big run up that no one could
explain, because no one wanted to put a stock in [the index] and
then have it drop 25% the next week," Mr. Blitzer said. Tesla stock
is up sixfold this year and trading at more than 100 times forecast
2021 earnings.
The profits rule is only the most glaring of many conflicts
between an investor tool and a gauge of the market. Investors want
anything that helps performance and eases trading, while a measure
of the market should be comprehensive. The S&P 500 is by design
not comprehensive, including only big stocks, but if it can exclude
such a huge company as Tesla, what is it for?
The answer, according to S&P's website, is that it "is
widely regarded as the best single gauge of large-cap U.S.
equities." In the world of investment, that is pretty much all
there is: If everyone uses the S&P as the benchmark, you have
to pay attention. As Tesla's move last week showed, the sheer
weight of money means the S&P matters.
This has perverse effects, because other indexes, with different
rules, are used elsewhere. The result is that the same stock can
sit in several benchmarks, attracting money from those tracking,
say the eurozone, as well as the U.S. -- and contributing to the
widely used futures tied to those indexes.
Consider TechnipFMC PLC. The British-registered oil-services
company is the second-smallest member of the S&P by value, and
so is at risk of being booted out next month to make way for Tesla.
(It might also stay, as the committee isn't forced to remove any
particular company, any more than it was forced to add Tesla.)
On Wednesday, TechnipFMC -- formed from the merger of French and
U.S. companies -- was one of the best performers in the index. It
was also one of the best performers in the Euro Stoxx index, where
it is classified as a French company, and in Vanguard's popular
FTSE Europe ETF, where it is also treated as French. So a
diversified portfolio using benchmarks from different index
providers would probably have TechnipFMC twice -- neither of them
in the place where it is legally based.
When index investing got going in the 1970s, this wasn't a
problem because almost all companies were listed in the country
where they were registered, based and did most of their business.
Globalization has broken the links, with companies shifting for tax
reasons, more cross-border mergers and many multinationals doing
most of their business outside their home countries.
"Where a company is listed is pretty much irrelevant in today's
situation," says Martyn Hole, an investment director at Capital
Group, whose Capital International provided the "CI" in MSCI. (They
are no longer linked.) He says aside from some corporate-governance
rules and governmental pressure, stock pickers should focus on
where companies make their money, not where they happen to be
listed.
The index providers are in a bind, sometimes focusing on listing
location, sometimes on legal status, and other times on where a
company does its business -- in part because of what investors
want.
MSCI includes foreign-listed companies in its home-country
indexes where there are a lot of them, as with Israel, China and
the Netherlands. There aren't many German companies listed
overseas, so German vaccine maker BioNTech SE, which IPO'd on
Nasdaq, doesn't qualify for MSCI's German or European indexes.
Because it is German, it doesn't qualify for MSCI USA either. On
the other hand, Tesla has been in MSCI's U.S. indexes since 2010,
because there is no rule on profits.
Most of these problems can be avoided by using very broad global
indexes, such as MSCI All Country World or FTSE All-World, which
have several large ETFs tracking them. There are still differences
in which stocks qualify, notably nonvoting shares, but such an
approach does at least avoid the biggest anomalies.
Investors still need to pay attention. There are vast amounts of
money being shifted around based on strange and conflicting
rules.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
November 22, 2020 11:14 ET (16:14 GMT)
Copyright (c) 2020 Dow Jones & Company, Inc.
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