Elon Musk, CEO of Tesla, will be on the construction site of the Tesla Gigafactory in Grünheide near Berlin on September 3, 2020.
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Tesla’s addition to the S&P 500 at close of trading this Friday will be one of the biggest trading days in history, but it’s just the latest example of an ongoing trend: index managers making the decisions about what goes in and out These indices are becoming more and more influential.
“Rebalancings have become major trading events because more investors are tied to indices, so trading volume has increased significantly during the rebalances,” Harry Whitton of market maker Old Mission told me.
Whitton noted that the toughest trading days these days tend to be due to large index adjustments. The S&P 500 is rebalanced on Friday one of four days of the year. Friday’s realignment should mean a record level of trading activity due to the addition of Tesla to the S&P 500 to close.
In addition to the S&P rebalancing, several large ETFs will also be rebalanced on Friday, including the Invesco QQQ Trust (QQQ), which is indexed to the red-hot NASDAQ 100, and the Renaissance Capital IPO ETF (IPO), which is already active Ruptured due to the rush of recent IPOs and $ 700 million in assets under management.
What happens when indices are rebalanced?
Rebalancings usually involve changes in the weighting of the companies listed in the indices, but may also include additions or deletions to the indices (known as “reconstitution”). Mutual funds, ETFs, and others who wish to mimic the behavior of the index then have to buy or sell the stocks in proportion to their weighting in the indices.
Indexes need to be rebalanced and restored as some companies no longer adhere to the index’s rules or guidelines. Others not included in the index meet the inclusion criteria.
Some realignments are semi-annual, quarterly, or even monthly. Some indices rebalance each other in a day while others spread the trade over several days.
The realignment of the S & P 500 takes place four times a year. The Russell 1000 and Russell 2000 realigns once a year.
Deciding what to include in an index is a complex matter. Some use “mechanical” methods that automatically add stocks to the index when they meet certain criteria. The Russell 1000, for example, will simply contain the 1,000 largest stocks in the United States. The S&P 500, on the other hand, is selected by a committee that aims to include the largest companies in the US. The included are weighted according to market capitalization.
The realignment of the index has become important because so much money is now tied to these indexes. Take the SPDR S&P 500 (SPY), the largest ETF in the world with over $ 320 billion in assets under management. This ETF tries to track the performance of the S&P 500. The ETF issuer (in this case State Street Global Advisors, which operates SPDR) licenses the S&P 500 index from S&P Dow Jones Indices. If the index is rebalanced, the issuer (in this case S&P Dow Jones Indices) will notify the issuer (in this case State Street) of the changes being made. The issuer then has to decide what to buy or sell and how to conduct the transaction. This transaction leads to significant trading activity.
Rebalancing the Nasdaq 100: Tech on the move
The Nasdaq 100 Index consists of the 100 largest non-financial companies listed on the Nasdaq and is the basis of the Invesco QQQ Trust ETF (QQQ). It is rebalanced four times a year, but companies are only added or deleted from the index (“reconstitution”) once a year. This reconstitution will take place on the Friday after graduation. Over the weekend, Nasdaq announced that six companies will be added to the index and six will be deleted.
The six companies are: American Electric Power Company (AEP), Marvell Technology Group (MRVL), Match Group (MTCH), Okta (OKTA), Peloton Interactive (PTON), and Atlassian Corporation (TEAM).
The six to remove are: BioMarin Pharmaceutical (BMRN), Citrix Systems (CTXS), Expedia Group (EXPE), Liberty Global (LBTYA / LBTYK), Take-Two Interactive Software (TTWO), and Ulta Beauty (ULTA).
Investors measured on the Nasdaq 100 must buy the added stocks and sell the deleted ones. As the impact of passive investing increased, the amounts invested – and the volume of trading related to the realignment – have increased significantly.
Invesco QQQ Trust (QQQ) is the fifth largest ETF in the US with assets under management of around $ 150 billion. The Nasdaq 100 Index is also a benchmark for a variety of additional financial products such as options and futures.
Tesla will be the greatest balance in history
Because of its size, indexers linked to the S&P 500 are expected to buy approximately $ 80 billion worth of Tesla to be included in the S&P 500, meaning issuers will have $ 80 billion of the remaining shares in the S&P 500 have to sell. That alone would do the biggest realignment by far in S & P’s history: The previous record of $ 50.8 billion was in September 2018. Tesla is expected to be around 1% of the S&P 500’s market cap after its inclusion turn off.
Rebalancing: A game of cat and mouse
All of this trading – and that money – leads to a precarious game of cat and mouse between the people who need to buy and sell stocks (those tied to indices like ETFs and mutual funds) and those who can buy on or sell to them (the brokerage community).
“The goal of the indexers is to buy Tesla at close of trading next Friday and sell the other companies at close of trading,” said Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.
This, says Silverblatt, brings Indexers into conflict with the trading community: “If you are a trader or an investor, your goal is to buy or sell to the Indexers for a profit.” To ensure that they have the right stock balance, issuers often enter into agreements with brokerage houses to deliver the stocks they need to buy or sell on the trading day.
“The indexers pay a fee to the trading community to ensure they get at least some of the stocks they need,” noted Silverblatt. “It’s all part of the business cost.”
Lots of planning, but nobody knows what’s going to happen
Basically, this tsunami of trade shouldn’t change prices as the business of listed companies doesn’t change. However, there are significant changes in supply and demand caused by the inclusion or exclusion of indices and this can and does affect prices.
And that makes these events a bit nerve-wracking, especially when you’re dealing with something as big as Tesla and a little bit insecure.
“The truth is, we don’t know exactly what’s going to happen,” Silverblatt told me.
Index managers are the new global asset managers
Ben Johnson, Head of Global ETF Research at Morningstar, says the key takeaway is that once obscure index providers are now key players in determining who owns what in the investor world.
“These index providers are much more than just index providers – they are effective portfolio managers,” said Johnson. “They are not asset managers, but they determine where the money goes by deciding who gets in and out of these indices.”
As a result, the index committees of the major providers – whether for S&P, NASDAQ, FTSE or MSCI – have become hugely influential: “These index committees have become one of the largest discretionary asset managers on the planet,” Johnson told me.
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