Tesla (TSLA 5.10%) was one of the market’s hottest stocks two years ago. Its business was becoming more successful, and its stock was set to have one of the best years for any large-cap corporation on record. Furthermore, the automaker was invited to join the S&P 500 (GSPC 0.13%) index, which boosted share increases as investors predicted that index funds would be forced to buyers of the company at any price.
Fast forward to now, and index fund investors have paid a high price for Tesla’s inclusion in the S&P 500 in late 2020. The stock of the electric vehicle (EV) pioneer has not only given up major gains since 2021 but is also down significantly from its levels two years ago, despite the fact that the S&P has managed to achieve a positive return during the same time period.
Year one’s strength gives way to year two’s weakness.
S&P Dow Jones Indices provided index funds plenty of notice that Tesla will be included in their most prominent index. More than a month occurred between the first announcement of Tesla’s inclusion and the effective date of December 21, when Tesla’s stock price had a direct impact on the S&P 500. According to S&P analysts, index funds would have to pay around $90 billion for shares to match Tesla’s weighting in the index. Many of them paid close to the split-adjusted $232 share price at the previous Friday’s close of business, Dec. 18.
The auto stock was turbulent in the first year of Tesla’s inclusion in the S&P, but it managed to stay in the bull market and outperform the index. Tesla shares were up about 70% from where they entered the index in early January 2022, compared to the S&P 500’s 30% increase.
2022 has not been as kind. Tesla has not only given up all of its gains, but it has also continued to fall below the price that index fund investors paid for their shares when it was introduced to the S&P 500. Tesla stock recently dropped below $170 per share, a 27% decrease from the entrance price for index investors and significantly failing the 10% total return earned by investing in the S&P 500 over the same time period. This translates to a $24 billion damage to index fund returns linked to Tesla’s plunge.
The price of index forerunning
The majority of the issue originated from the compulsory nature of index fund purchases. Investors could have purchased Tesla shares for roughly $135 per share on a split-adjusted basis immediately before the mid-November index announcement. Nonetheless, during the course of the month, that price rose rapidly, stabilizing above $200 per share until a last-minute rush pushed it even higher.
Tesla was in a special situation because its market value had grown so enormous before it was invited to join the S&P 500. That doesn’t happen very often, but in this case, it was due to certain certification standards that Tesla took a long time to meet. Even with smaller corporations, the same phenomena occur, but with a less dramatic financial impact on index fund holders.
Investors in index funds have no choice.
Index investing is an excellent way to participate in the stock market’s long-term gains, and the lack of active trading allows index funds to have extremely low fee structures. However, index funds’ slavish adherence to monitoring their target benchmarks comes at the expense of introducing artificial stock price movements when constituent stocks are added, and funds frequently pay more for their shares than they would otherwise have to.
In the long run, it’s likely that Tesla stock may recover from its current lows and begin to outperform the S&P 500. However, index investors aren’t thrilled that they missed out on Tesla’s greatest years only to buy at an unfavorable time for the EV company.
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