Tesla shares were down 21% overnight as it was passed over for membership of the S&P 500 index. It’s still worth almost as much as Toyota, VW and Daimler combined, but the squeeze up on the expectation of joining the world’s most tracked index is over, for now.

Tesla remains the largest company outside the S&P 500 so its membership in the index is still likely. While membership is ultimately decided by S&P’s index committee, Tesla would be a big anomaly if it remained outside the index while meeting its membership requirements, meaning the index-effect on this stock’s price isn’t going away. Keep in mind that its current market value still gives it an indicative weight of roughly 1% in the S&P500, an index with $11 trillion tracking it. 1% of $11trn is around $110 billion that index tracking funds would be required to buy of Tesla stock, not that far off the $82bn it shed last night.

Passive index tracking isn’t broken, but Tesla is a wonderful case study to highlight how the massive size of passive funds is influencing pricing in the equity markets. Tesla was squeezed up on the expectation of index membership then dumped when its inclusion was nixed. The fundamentals of Tesla’s business and the production of its cars didn’t change a bit, but in one day it lost more value than the market cap of ANZ and NAB combined.

If you know that $11 trillion of passive money will be obliged to buy into a stock, it’s probably a good idea to get in. But the tale of Tesla shows that the index effect can throw all valuation metrics out the window. The price is determined by expectations about index inclusion, meaning the company’s value is set by its potential participation in, at its base, an exercise in the measurement of the equity markets.

It’s arguable that the market has been rational in the way it has priced Tesla. But is the system that set up this scenario entirely rational? When a measurement tool – the index – becomes a major factor in market pricing, perhaps we need to think about how we are allocating capital.

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James Popovic

Excellent point raised here Tamas

Jordan B

In fairness, TSLA’s bubble beget this problem (at least, at this scale), not the other way around. If TSLA was a smaller stock before meeting the requirements for joining the S&P, the index effect would be substantially smaller. (And in any case, would be a one-off increase in buying activity)

Michael Whelan

James - Not exactly sure what the point he's making here. Forward-running on the expectation of TSLA's inclusion in the index which didn't happen, and then taking a (nasty) hit? Tamas - Can you clarify or advise which requirement(s) Tesla is lacking to be included in the S&P500 ? My understanding is while it meets the profitability criteria, if only just, that is the real sticking point.

Tamas Calderwood

Michael - from Bloomberg: "Tesla’s failure to make it into the S&P 500 may be connected to “question marks about the sustainability of regulatory emission credit sales which are currently underpinning earnings,” said Michael Dean, an analyst with Bloomberg Intelligence." And yes, the point is that front running index membership in expectation of huge demand from passive funds has been a big factor behind TSLA's price run. Jordan B - yes, TSLA's own bubble exacerbated this problem. The effect is much smaller for smaller companies, although still real. Tesla is a great case study on how passive funds can distort prices James - Thanks!