Look Under the Hood

Adam M. Grossman

TESLA JUST REPORTED financial results for its most recent quarter. For the fifth time in a row, it announced a profit. This was notable for a few reasons. Among them: Tesla’s increasingly strong performance again raises the question of why it’s been excluded from the S&P 500-stock index.

By way of background, the S&P 500 includes almost all of the 500 most valuable publicly traded companies in the U.S. But Tesla’s stock isn’t included, even though its size today would earn it a spot among the top 10—in the same neighborhood as Johnson & Johnson and Berkshire Hathaway. Still, it isn’t there and it’s worth understanding why.

Standard & Poor’s, the company that created and manages the index, is fairly specific with its criteria for inclusion:

  • A company must be based in the U.S.
  • Its market value must be north of around $8 billion.
  • Its shares must be highly “liquid,” meaning they’re easy to buy and sell on the open market.
  • The stock’s “float” must be at least 50%, meaning that it isn’t too tightly controlled by big shareholders.
  • The company must have positive earnings in the most recent quarter, as well as positive earnings, in aggregate, over the past four quarters.

In July, when Tesla last reported earnings, it cleared that final hurdle, delivering its fourth quarterly profit in a row. In the days following the announcement, Tesla enthusiasts fully expected the company to be admitted to the S&P 500. When S&P’s nine-person index committee next met, it did open the door to three smaller companies, including Etsy, a company that’s just 3% of Tesla’s size. But not Tesla itself. It was an odd result. One analyst called it a “headscratcher.”

What happened? The short answer is that nobody knows—or, I should say, nobody outside of S&P knows. And the folks at S&P aren’t saying. When the company issues announcements about index changes, its press releases are terse, with no explanation or commentary. In September, when a reporter asked S&P about Tesla, a spokesperson replied, “We cannot comment on individual companies and potential index changes.”

If you read through the 41-page methodology document available on S&P’s website, though, you’ll understand that Tesla’s exclusion was no mere oversight. In that document, you’ll repeatedly see the phrase, “at the discretion of the Index Committee.” In fact, the word “discretion” appears 35 times in that document. That pretty much explains what’s going on. Like a college admissions committee, S&P does have some guidelines, but ultimately its decisions are made behind closed doors for reasons that only certain employees know.

Is that the end of the story? If S&P’s posture is to be secretive, and it has no intention of changing, why even discuss this? The takeaway for me is that these quirks make it vitally important to understand the indexes underlying your investments. Index fund investing continues to grow in popularity and, overall, I believe that’s a good thing. But that has also led to a profusion of investment choices.

Today, there are at least six major index providers: In addition to S&P, there’s Dow Jones, which has a joint venture with S&P and which created the first market index, the often-cited Dow Jones Industrial Average. Then there’s MSCI, Russell, Nasdaq and CRSP, among others. Some companies, such as Fidelity Investments, have even built their own indexes. It’s estimated that there are more than 5,000 market indexes out there, along with thousands of index funds to choose from. This makes it hard, as an investor, to know what you’re buying.

To add to the confusion, many indexes have similar names but not necessarily the same strategy. Once you move beyond the most basic, broad-based indexes, things can get tricky. Here’s one example: To complement its flagship 500 index of large companies, S&P also offers an index of mid-cap stocks and an index of small-cap stocks. Put them all together, and you might think you’d end up covering the entire U.S. market. But that isn’t the case.

Because of S&P’s discretionary power, some stocks aren’t included in any of those three indexes. One such stock: Tesla, which has been left out in the cold. The index committee won’t let it into the large-cap index. But because of its size, it isn’t eligible for the mid-cap or small-cap index, either. Result: If you had owned those three basic indexes, thinking you had exposure to the entire market, you would have missed out on Tesla’s 398% gain this year. Another one you would have missed: Zoom, with its 654% gain. Zoom also isn’t included in any of those three seemingly comprehensive indexes.

S&P does include both Tesla and Zoom in other indexes, including one called the Extended Market index. But if you hadn’t been aware of that, you would have missed out on those two stocks’ dramatic gains. In fact, funds tracking those mid- and small-cap indexes have suffered losses this year, while the Extended Market index is up more than 10%. It’s differences like this that make it critically important to know what you own.

The bottom line: Before making an investment, always, always look under the hood.

Adam M. Grossman’s previous articles include Follow the FedSave and Give First and Don’t Play Politics. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.

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