Tesla Going in S&P 500 Is What the Smart-Beta Geeks Warned About

Concerned that Tesla Inc. may prove to be a drag on the S&P 500 when it enters the index after such a gigantic rally? You’re not alone. There’s a group of Wall Street data nerds who have been making a similar case against traditional stock benchmarks for years.

Some of them are quants who fly the flag of “smart beta,” that hybrid of active and passive management that holds among other things that indexes weighted by market value suffer by chaining their fortunes to big and bloated companies. Tesla’s imminent entry into the S&P 500 is stirring their passions by framing the debate in particularly stark terms.

Pioneers such as Rob Arnott are making the rounds and publishing studies in the run-up, trumpeting data that purports to show that megacap companies have the potential to harm passive returns. The view accords with the smart-beta ethos that says many stock indexes stumble when the massive companies that dominate them run out of room to grow.

To illustrate the drag, Arnott and a colleague at Research Affiliates wrote a paper titled “Tesla -- The Largest-Cap Stock Ever to Enter S&P 500: A Buy Signal or a Bubble?” Looking at 31 years of data, they found that when a company is big enough to enter the index as one of its 100 largest members, it falls 7% over the following year, on average. Meanwhile, the average deleted company beats the gauge by 20% after being kicked out.

It’s evidence that benchmark overseers such as S&P Dow Jones Indices “buy high and sell low,” resulting in a performance gap of 24% between megacap entrants and discretionary deletions over the next 12 months, according to the paper. That ultimately costs investors money, and exposes what quants such as Arnott consider a fundamental flaw of market-cap indexes -- too much dependence on companies whose best days may be behind them.

“This Tesla addition is a beautiful illustration of that,” Arnott said in a phone interview. “It’s run up 800% from the March lows. Now you want to add it?”