By Michael Wursthorn and Gunjan Banerji 

Additions and subtractions to the S&P 500 are normally a ho-hum affair. The 509th biggest company in the U.S. might jump to 497th place, and thus into the index. Investors who track it buy the one stock and sell another.

But no one has ever tried to add Tesla Inc., a $555 billion company prone to huge swings in price. That's happening next month, and it's causing headaches across Wall Street.

To avoid missteps, S&P polled big investors on whether they would prefer adding Tesla's weight all at once on Dec. 21 or split over two trading days in December -- an unprecedented move for S&P.

Asset managers and trading desks across Wall Street have held virtual summits to debate the matter. The vote from many appears to be for the two-day option, partly because of Tesla's size, along with the potential for elevated volatility in the stock market.

"If we begin to anticipate a worst-case scenario from what could happen from the Thanksgiving holiday, we could expect greater than usual volatility," said David Mazza, a managing director and head of product at exchange-traded-fund manager Direxion, referring to a possible further surge in coronavirus cases. He endorses Tesla's addition to the S&P 500 over two separate trading sessions.

Tesla's addition to the index is expected to be particularly challenging because the company will be the largest to ever join, and it is expected to make up at least 1% of the gauge. At its current value, it would be the sixth-largest company in the S&P 500, just bigger than Berkshire Hathaway Inc. and smaller than Facebook Inc.

The stock, which has a cultlike investor base, has surged more than 40% to $585.76 since Nov. 16, when S&P announced its intended inclusion, extending its gains for the year to sevenfold. The S&P 500 itself is up 13% in 2020.

The decision rests with S&P, which said it intends to announce results of the consultation on Monday. Regardless of the outcome, investors and traders expect the market for Tesla shares to heat up even further ahead of the inclusion. Goldman Sachs Group Inc. predicts shares will eventually touch $600, a 2% gain from current levels, by the time Tesla joins the index.

Tesla's inclusion is expected to put more than $100 billion into motion. Index funds will have to sell smaller stocks already in the S&P 500, somewhere between $60 billion and $80 billion depending on Tesla's market cap, and use that money to buy shares of the car maker, asset managers and traders said.

Actively managed funds benchmarked to the S&P 500 are projected to buy $8 billion of Tesla shares, Goldman said in a recent note. The move will also spur trading within separately managed accounts that use the S&P 500 as a benchmark, as well as hedging activity by trading firms that buy and sell ETFs.

Those sums are big, but investors say Tesla's addition to the index would normally be manageable in a single day. Shares of Tesla are widely traded, with daily volumes reaching as high as nearly $65 billion in mid-July, suggesting there is enough liquidity to cover the trade.

The trade date, Dec. 18, coincides with a once-quarterly event known as quadruple witching, the Friday near the end of each calendar quarter on which options and futures on both indexes and stocks expire simultaneously. Volume is usually heavy on those days and would help boost liquidity on the day of Tesla's inclusion, investors said.

They said the curveball is accounting for other potential volatility in the stock market tied to Covid-19 or signs the economic recovery is faltering. The market has been particularly rocky this year. There have been more single-day stock moves of at least 3% for the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite than in any year since 2008.

Investors who had shared their opinion with S&P have offered another suggestion that appears to have earned broad support: breaking the trades up over two different quarters, according to people familiar with the discussions.

A longer break between the trades would help asset managers digest any sharp moves related to Covid-19 or other news the market doesn't take well and help keep funds in line with benchmarks, investors said.

"A stepped approach over multiple quarters helps with the liquidity challenges. There's good precedent for it," said Chris Johnson, head of ETF capital markets at Charles Schwab Corp., referring to MSCI's two-phased inclusion of China A-Shares to its emerging-markets index in 2018.

There are also concerns that the flurry of buying that comes with index inclusion will temporarily drive up Tesla's share price for firms forced to buy around the addition. That means the stakes are high for S&P and index funds, which account for about 41% of the assets that track the S&P 500.

"The people who will pay the price if S&P screws up are the investors in passive S&P" funds, said Ben Inker, head of asset allocation at investment manager GMO, which oversees about $60 billion in assets.

If the huge burst of demand ahead of inclusion disappears, Tesla's shares could fall dramatically after they join the gauge, he added.

Timing is hard for investors and indexers alike. Yahoo's market capitalization peaked less than a month after it was added to the S&P 500 in December 1999 -- just before the burst of the dot-com bubble. Qwest Communications' market cap peaked the same day it was added to the index in July 2000. Neither stock trades today.

"Why am I the sucker who has to buy it after the stock is up fivefold?" is what one might wonder if forced to buy Tesla shares after such a tremendous run-up, said Mike Bailey, director of research at FBB Capital Partners, which oversees some Tesla shares.

Write to Michael Wursthorn at Michael.Wursthorn@wsj.com and Gunjan Banerji at Gunjan.Banerji@wsj.com

 

(END) Dow Jones Newswires

November 29, 2020 05:44 ET (10:44 GMT)

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