The Jerusalem Post
The company Tesla replaced in the S&P 500 Index is outperforming it handily
The perils of stock picking illustrated.
The company Tesla booted from the S&P 500 index has vastly outperformed the electric automaker by a “stupendous margin,” analysts at Research Affiliates pointed out recently.
Tesla entered the S&P 500 to great fanfare on Dec. 21, 2020, in a rebalance of the index. It surged well over 20% in its first month, but since then has fallen, standing now with gains of about 5%, lagging the S&P 500’s near-16% gain in that same timeframe.
Tesla’s entry meant one company had to leave, as the S&P 500 does not become the S&P 501 when a new company joins the club. To make room, S&P had to kick out Apartment Investment and Management from the index, but since that December 2020 rebalance, the company’s stock spiked almost 60% — and though it went down still stands around 40% higher than it did when it got the boot.
According to analysis from Research Affiliates’ Rob Arnott, Vitali Kalesnik, and Lillian Wu, Apartment Investment and Management, this pattern is not uncommon. Frequently, additions to the index underperform and removed companies often do very well. In their view, a struggling stock getting kicked out of the index during a rebalancing means getting the axe at a low point. On the other side, a hot new stock getting added to the index is typically trading at a high point.
The authors pointed out that though index investing is passive, the actual indexes aren’t necessarily passive as the decisions on which companies to include in the S&P 500 is controlled by a committee. And the index changes to compensate for companies’ valuations and new entrants periodically, not automatically.
A $10,000 investment in TSLA on Dec 21st 2020 decreased to about $9,800 at the end of June; . Invested in AIV it increased to about $14,800.
An investor who had $100,000 in, say, an S&P 500 index fund on Dec. 21 when the rebalancing happened would be around $500 poorer had no rebalance happened. “Unfortunately, this cost is totally unnoticed by investors because it is baked into the index’s performance,” the authors wrote.
The analysis suggests these are hidden costs of indexing and Tesla’s underperformance and Apartment Investment and Management’s outperformance should have come as no surprise given historical patterns. But of course, there was no guarantee this time was going to be like the previous ones.
“Rules-based index construction rather than committeeselected indexes tend to be more resilient and consistent” adds Jonathan Gerber CPA, President of RVWWealth.com. “Those of us who have sat on committees understand that they frequently arrive at suboptimal decisions” he adds. Many astute investors prefer predictability and a systems-based selection process when smart-indexes are constructed In addition indexes such as the S&P 500 are cap-weighted which in effect means that having made the selection of which stocks to include, the weighting within the index is based on the total market value of the company relative to others in the index.
The problem with cap-weighted indices—meaning the stock carrying the largest percentage ownership in the index is the one with the biggest market capitalization—is that they are vulnerable to concentration. As a company increases in value, so, too, does its weight in the index. The index’s performance is therefore more greatly influenced by this stock.
This results in always being overweighted to the most expensive companies and underweighted to the least expensive companies – and many successful investors prefer an approach that looks at the fundamentals of a company rather than simply its price in deciding to include it in a portfolio. “Looking at fundamentals is how one typically buys anything, and investing should be done in the same way” says Gerber.
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