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Why does an index matter to individual companies?

We explore Tesla’s move to the S&P 500, and the lessons investors can learn from it.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

On the face of it, what index a company’s shares are included in shouldn’t matter. It makes no difference to how they operate.

But we’ve seen recently with Tesla that being included in an index can create waves in the share price. The reason for this has a lot more to do with the power of indexes than individual companies.

First up, what’s going on with Tesla?

From 21 December 2020, Tesla will become a member of the S&P 500 index. That comes after the group met a number of conditions to be included in the S&P, including reporting four consecutive quarters of profit.

Chart showing Tesla net income ($)

Past performance isn’t a guide to future returns. Source: Refinitiv, 30/11/2020.

News of the move in mid-November has pushed Tesla’s share price up. After the announcement, they swelled 22% in just two days and then rose further. This sits on top of what was already a soaring share price, and the shares are now up fivefold in 2020.

Why have the shares reacted so positively?

Investors must keep in mind the latest share price rally has largely been driven by sentiment and market mechanics. Not because of any fundamental change in the business.

Remember that returns of this nature are exceptional and past performance is not a guide to the future. Ultimately as with any investment, you could still get back less than you invest.

The key thing to ask is whether Tesla shares are truly worth five times more than in 2019. You might think so, but this is a decision that needs to be made on the fundamentals of a business. A change in index doesn’t alter how the core of a business operates, or its long-term prospects.

So why does a change in index matter?

Indexes are used by active fund managers as benchmarks on which their performance is judged. While active fund managers will aim to try and beat an index, at the other end of the spectrum, passive funds aim to replicate an index. As such, the makeup of the world’s largest indices will have a knock on effect for the global investment community.

It’s very rare for such a big company to join a blue-chip index like the S&P. A market cap of $544.1bn will put Tesla in the top ten biggest companies in the index. Simply put, that means Tesla is too big for fund managers to ignore.

Smaller fish could be left out of the equation when it comes to building a portfolio or replicating an index in a passive fund. But Tesla’s size means any share price swings could affect the whole index. The stock has been notoriously choppy, meaning fund managers will have to think hard about including Tesla or not.

If an active fund manager decides not to add Tesla to the portfolio, and Tesla shares were to rise sharply, it would make beating the benchmark a much more difficult task.

At the moment about $11trn of assets track (by indexing or benchmarking) the S&P.

We suspect most active managers will buy at least a small amount of Tesla because of its weighting in the index. And passive funds will likely have to buy tens of billions of dollars’ worth of Tesla shares, because for many their aim is to replicate an index as closely as possible. This is one of the reasons for the share price inflation of recent weeks, as the stock has been bought in anticipation.

What does all this mean for me?

Situations like this are a reminder to always keep focus on the fundamentals of a business. Induction into a new index can certainly be lucrative for companies, because of how funds operate. But this doesn’t change the story of an individual company.

It can be tempting to think something like this is better news than it really is when you see a share price rise. But it’s important to understand what’s going on underneath the hood of a company – and in the case of Tesla, it will remain the same machine as the one currently listed on NASDAQ.

This article isn’t personal advice. If you’re not sure if an investment is right for you, then you should ask for advice.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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