Tesla has been the Excalibur sword that active investors needed to fight the growing passive industry over the last four months. With the stock excluded from most indexes due to lack of profitability and float limitations, it has been one of the big market cap names that active investors could invest in for outperformance. While an investment in Tesla was problematic for active investors from 2014 thru 2019, the electric car maker has shifted gears in the last few months with over-weighted owners now rejoicing. Recent momentum in the name has lifted the stock 250% since October.
This ‘Ludicrous Mode’-like move has been a significant benefit to active investors. As you can see in the list of the largest holders below, there are very few passive investment mutual funds or ETFs on the list. I count less than five passive vehicles versus the usual 10-15 that you will find for the average large cap U.S. stock. For now, active investors are happy partying it up with Ron Baron at the mic, while passive investors can only look at the pictures of the event online. But this will soon change.
At some point, the major indexes will look past the float issue and all attention will be on the profitability metric to consider Tesla’s inclusion. According to S&P, they consider a company eligible for inclusion in its biggest index as one that shows four trailing quarters of GAAP profitability. Tesla now has two quarters of profits behind it, but it does need to lap the large losses in the Q1 and Q2 of 2019. So as soon as Tesla can make enough money to offset these quarters, it will be considered for inclusion. And with a market cap well over $100 billion, it would also help S&P if another giant market cap left the index, otherwise the passive funds would have to significantly rebalance their 100, 500 or 1000 total holdings. But it is probably safe to say that a potential Tesla index addition will be most talked about in the second half of 2020. Will passive investors be ready to take the Excalibur sword from active investors?
Once it does become added to the big indexes, how much buying will be necessary to satisfy the passive investment buckets?
With the help of the Visual Capitalist and BlackRock, you can see below where Tesla will be bought by the ETFs. While currently included in the QQQ Index and some smaller Technology and ESG Indexes, the real big dollars are in the Large-Cap and All Cap Indexes where almost $3 trillion in AUM is waiting to buy. Most of the AUM in the two largest circles below are U.S. or Global Index focused. While the S&P 500 ETFs will be looking to buy a 0.5% stake in Tesla, the U.S. All-Cap ETF will be looking to own maybe a 0.4% stake while the Global All-Cap Funds could be in the 0.3% range. But all together, it would be safe to say that there will be about $8 billion in buying by the ETFs once Tesla makes its way into the bigger indexes. Now let’s go ahead and double this number since we can’t ignore the passive mutual fund industry which is about equal in size and will also be buying Tesla. So $16 billion in big bucket passive demand will need to be bought on the date of inclusion which is greater than 10% of Tuesday’s market cap.
Don’t want to own Tesla but you have all of your money in passive investments? Tough. The stock will be quietly driving into your portfolio this year. You can hope it will be at a lower price, but there will be a world of active investment managers and hedge funds trying to front run you if they see value in owning the company. And closet active indexers will no longer be able to ignore Tesla if it is included in their benchmark. So if you think that Tesla is currently too expensive to own in a passive investment vehicle, welcome to one of the most debated finance topics today. Once Tesla makes it into the index, there will be nothing to stop the daily buying of shares until the passive freight train begins to slowdown. For every $1 going into a large cap passive vehicle, Tesla will get ½ of a cent.
There is no bigger discussion in the investment management world today than the takeover of passive investment management at the expense of active. For equities, the market share lines crossed at the end of last year putting passive on top. This trend has been in place since the Global Financial Crisis (GFC), but really accelerated in the middle of the decade, helped by the markets ongoing annual positive returns, and the increasingly correlated returns among equity components leading to investors preferring to buy the lowest cost investment vehicles available (which were index mutual funds and ETFs). According to Goldman Sachs, since the GFC, $2.8 billion has left U.S. active mutual funds while passive has gained $3 billion. The charts show a pretty seamless transfer from one pocket to the other.
This shift in assets has left its mark in the U.S. equity markets. Some would argue that new money flowing into passive is evenly spread through the buying of the indexes’ components (from buying a 4.8% Apple Inc. position down to a 0.1% H&R Block position) and thus no company’s market cap is overly rewarded over another. While this is true of the index buying, what is forgotten is that the assets being sold are not from a blind large index. The assets being redeemed are either from poorer performing asset classes or strategies (like small caps or value stocks) or from active portfolio managers who run portfolios that have much lower market cap concentrations than the S&P 500 (or the index they are benchmarked against). They might even own several stocks which are outside of their index and thus penalized during this 10-year rush into the passive indexes. (Unless of course they are a small cap fund running a 5% Apple Inc. position in which case they likely crushed it.)
A glance at the 15-year returns of major strategies below notes the headwinds that active players have been fighting to keep their assets under management. Small cap and value strategies have typically outperformed over the long term, but over the last 5 years they have been sources of cash as investors have left and hunted for better returns.
@nosunkcosts: Smallcaps have had the worst risk-adjusted returns for 15 years. That’s gotta make the lives of active managers harder.
Active managers can’t wait for the turn. It has been tough for them to run a diversified fund when the top five stocks make up 17% of the index. If they are running a diversified portfolio then by SEC rules their top five positions cannot make up more than 25% of their assets. And often a fiduciary like a pension fund or endowment will give you a sideways glance if you are too concentrated at the top of your fund.
So say that you had perfect visibility on 2020 and knew that the five stocks below were all going to significantly outperform. The best you could position would be a 5% weight into each name. Or maybe if you knew the exact winner you could put 21% into that stock which leaves 4% to be spread over the other four holdings. But again, placing 21% into a fund with large institutional weightings would probably get you fired. So bottom line, it has been difficult for active managers to gain an edge on the index when they can’t significantly overweight the largest and best performing holdings in that index. Large cap portfolio managers would rather own underweights in the top five stocks and overweights in their favorite remaining 495 names.
Below I have listed the annual performance of the top five market cap names from the previous year end. Let’s call this portfolio the “I Love Passive” Portfolio. As you can easily see, the “I Love Passive” top five portfolio has easily outpaced the S&P 500 Index itself since the flows out of active and into passive have accelerated. In fact, the ILP Portfolio has won for the last six years and is off to the races again in 2020. Barring a catastrophic fraud at one of the top five companies, I’d expect this strong performance to continue as long as active assets are being shed to passive. One would think that at some point the valuations of the top market cap companies in the index would put a pause on the mega-cap outperformance. But remember, the index doesn’t discriminate by valuation. It only acts by percent weight in the index, so if another dollar comes into the S&P 500 index fund, it will buy another $0.048 of Apple Inc.
So what will end this party? We know with certainty that money flows will chase performance. So, if there are some outsized forces that could cause small cap stocks, value stocks, cyclical stocks, foreign stocks, or any other non-S&P 500 stock to outperform, then eyebrows would be raised, and anxious investors could shift. Maybe this would be the result of a buyout wave of smaller companies with little multiples by larger companies with big multiples. Or, maybe it would be caused by a dramatic change in the global economy that led to new shortages of certain goods and services or emerging monopolies caused by regulatory changes. Or, maybe a dramatic decline in the U.S. dollar that would cause a shift to multinationals with more global earnings, or even foreign-based companies exhibiting better growth prospects.
We won’t know what caused the pause in assets moving to passive until after it happens. But when it does, look for the megacaps in the big indexes to be challenged and for active investors everywhere to scream like their favorite team won the championship on the final play. Until then, the asset management industry can watch a few firms (that shall remain nameless) eat all of the cake while scrambling for the crumbs. Everything is cyclical and someday active management will come flying back with forks and knives in hand.
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