Earlier this week, Tesla reported financial results for its most recent quarter. And for the fifth time in a row, it reported a profit. This was notable for a few reasons. Among them: Tesla’s increasingly strong performance again raises the question of why it has been excluded from the S&P 500 Index.
By way of background, the S&P 500 is a group of (most of) the 500 most valuable publicly traded companies in the United States. But Tesla’s stock isn’t included, even though its size today would earn it a spot among the top 10 in that elite group—in the same neighborhood with Johnson & Johnson and Berkshire Hathaway. Still, it’s not there, and it’s worth understanding why that’s the case.
Standard & Poor’s, the company that created and manages this index, is fairly specific with its criteria for inclusion in the S&P 500:
- A company must be based in the U.S.
- Its market value must be north of about $8 billion.
- Its shares must be highly “liquid,” meaning that 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 other, smaller companies, including Etsy, a company just 3% the size of Tesla. But not Tesla. It was an odd result. One analyst called it a “head scratcher.”
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 they issue announcements about index changes, their 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, they repeatedly use the phrase, “at the discretion of the Index Committee.” In fact, the word “discretion” appears 35 times in that document. And that pretty much explains what’s going on. Like a college admissions committee, S&P does have some guidelines, but ultimately, their decisions are made behind closed doors for reasons that only they know.
So is that the end of the story? If S&P’s posture is to be secretive, and they have no intention of changing, then 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 created the first market index. Then there’s MSCI, Russell, NASDAQ and CRSP, among others. Some companies, such as Fidelity, have even built their own indexes. Altogether, it’s estimated that there are more than five thousand market indexes out there now and thousands of index funds to choose from. This makes it hard, as an investor, to know what you’re buying.
Especially confusing is the fact that 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’s not the case.
Because of S&P’s discretionary power, some stocks aren’t included in any one of those three. 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 or the small index either. The 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 out on: Zoom, with its 654% gain, is also not 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 funds 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 really know what you own.
The bottom line: Before making an investment, always, always look under the hood.