When you hear someone reference “the market”, they probably mean the S&P 500 index, at least here in the United States. It is a list of 500 companies (actually 505) selected by the US Index Committee that are meant to represent the US stock market. They have a set of criteria, but ultimately vote on who is in and who is out. The S&P 500 index creates a list of stocks and the percentage allocations to each are based on the size of each company*. Index funds take investor dollars and buys stocks to replicate the list as closely as possible. The index is the list, the fund is a way to invest in the list.

*Company size (commonly called ‘market cap’) is calculated by the number of shares outstanding multiplied by the stock price. Tesla’s size is roughly 950 million shares X $693 per share = $658 billion.

Until added to the S&P 500 on December 21st, Tesla was not part of “the market” as we commonly think of it, meaning it’s 8X stock price increase since March was not reflected in the S&P 500 returns. Tesla entered the index as the 6th largest company (Berkshire Hathaway is 7th), which meant index funds tracking the index had to collectively buy over $200 billion of Tesla stock on that day, without regard to the price. Institutional investors anticipated this and bought up lots of Tesla stock after the announcement, which likely drove the price up further.

To buy Tesla, index funds also had to sell $200 billion of other stocks, including all of their holdings in Apartment Investment and Management, which was booted from the index to make room for Tesla. That company recently performed terribly and the forced selling drove their price down even further. A natural reaction might be ‘good riddance, I’d rather own Tesla’, and I agree, but being forced to sell at a terrible price is not good investment strategy.

If there is one agreeable bit of wisdom for investors, it might be to buy low and sell high. The addition of Tesla to the S&P 500 is a clear example of how an index fund is designed to do exactly the opposite. New stocks are often added after their prices have run up dramatically, and stocks are removed after their prices have fallen. Forced buying and selling at the time of index additions and subtractions exaggerates the situation further.

Our preferred approach is to use a modified index fund, which assigns the percentage allocation to each investment based on its attractiveness in terms of relative price, profitability, cash flows, price momentum, and other fundamental measures of business performance. For a simple example, when Apple’s stock price is attractive relative to it’s profitability, the fund buys more. When Apple’s stock price becomes high relative to it’s profitability, the fund sells to reduce the position. Buy low, sell high, and repeat.

Tesla is an impressive company growing rapidly and dominating the electric vehicle market, not to mention rockets, solar roofs, and hyper loops. I suspect they are just getting started. Wanting to invest in Tesla makes sense, but an investor should ask “how much of my portfolio and at what price?”. If you own Tesla through an index fund, the answer is made for you: “it will be your 6th largest holding and you will pay whatever the price happens to be”. That price seems high.

To justify its current stock price, Tesla has a lot of growing to do. A recent paper from Research Affiliates suggests their current stock price implies Tesla will grow sales by 50% per year for a decade, and must do that at a higher profit margin than any other car manufacturer. That is a tall order, even for Elon Musk.

That paper goes on to say Tesla’s value equates to $1.4M per car it produces, compared to Toyota’s value of $19k per car. Tesla’s value is currently greater than the nine largest car manufacturers in the world, who collectively produce 121 times as many cars per year as Tesla. And they are coming for the electric vehicle business. Those ‘Nifty Nine’ manufacturers have massive production plans for electric vehicles.

On the other side of Tesla’s addition to the S&P 500 is the deletion of Apartment Investment and Management from the index. It might be surprising to learn that companies deleted from the index have outperformed the index on average in the following years. This is likely related to the price distortion created by the index.

In the chart below, the red dots indicate when the announcements were made for the addition of Tesla (orange) and the deletion of Apartment Investment and Management (blue). The red dashed line indicates the day the changes were made effective in the market. In both cases, prices moved quickly and dramatically to adjust for the expected buying and selling caused by the index changes.

Investing in an S&P 500 index fund is a great way to get diversified exposure to US stocks for a minimal cost, but that strategy misses the mark for investors who want to buy low and sell high over many years. The Tesla story is a glaring example of this reality.