Historic stock market volume is likely this week as Tesla goes into the S&P 500

The addition of Tesla into the S&P 500 at the close this Friday will be one of the biggest trading days in history, but it is only the most recent example of an ongoing trend: index managers who make the decisions of what goes in and out of these indexes are becoming increasingly influential.

“Rebalancings have become major trading events because more investors are tied to indexes, so the volume of trading during rebalances has gone way up,” Harry Whitton from market maker Old Mission told me.

Whitton noted that the heaviest days of trading are now typically on major index rebalancings.  The S&P 500 will rebalance on Friday, one of four days a year it does so.  Friday’s rebalance will likely see record levels of trading activity at the close due to Tesla’s addition to the S&P 500. 

In addition to the S&P rebalancing, several major ETFs will also rebalance on Friday, including the Invesco QQQ Trust (QQQ), which is indexed to the red-hot NASDAQ 100, and the Renaissance Capital IPO ETF (IPO), which has been on a tear due to the rush of recent IPOs and recently hit $700 million in assets under management.

Rebalancings usually involve changes in the weighting of the companies listed in the indexes, but it can also involve additions or deletions to the indexes (known as “reconstitution”).  Mutual funds, ETFs, and others who seek to mimic the behavior of the index must then buy or sell the stocks in proportion to their weightings in the indexes.

Indexes need to be rebalanced and reconstituted because some companies no longer fit with the rules or guidelines of the index. Others that are not in the index will meet the criteria for inclusion. 

Some rebalancing is done semiannually, quarterly, or even monthly. Some indexes rebalance all in one day, while some spread the trading out over several days.

In the case of the S&P 500, the rebalancing is done four times a year. In the case of the Russell 1000 and Russell 2000, the rebalancing is done once a year. 

Deciding what goes into an index is a complicated affair. Some use “mechanical” methods that automatically put stocks in the index if they meet certain criteria. The Russell 1000, for example, will simply include the 1,000 largest stocks in the United States. The S&P 500, on the other hand, is chosen by a committee that seeks to include the largest companies in the United States. Those that are included are weighted by market capitalization. 

Index rebalancing has become important because so much money is now tied to these indexes. Take the case of the SPDR S&P 500 (SPY), the largest ETF in the world, with over $320 billion in assets under management. This ETF seeks to track the performance of the S&P 500. The ETF issuer (in this case, State Street Global Advisors, which operates SPDR), licenses the S&P 500 index from S&P Dow Jones Indices.  When the index is rebalanced, the issuer (in this case, S&P Dow Jones Indices) tells the issuer (in this case, State Street) what changes are being made. The issuer than has to decide what to buy or sell, and how to do the transaction. That transaction results in significant amounts of trading activity.

The Nasdaq 100 Index consists of the 100 largest non-financial companies listed on Nasdaq and is the basis of the Invesco QQQ Trust ETF (QQQ).  It rebalances four times a year but companies are added or deleted to the index (“reconstitution”) only once a year.  That reconstitution will occur on Friday after the close. Over the weekend, Nasdaq announced that six companies would be added to the index, and six deleted.

The six companies going in are: American Electric Power Company (AEP), Marvell Technology Group (MRVL), Match Group (MTCH), Okta (OKTA), Peloton Interactive (PTON), and Atlassian Corporation (TEAM).

The six being removed are: BioMarin Pharmaceutical (BMRN), Citrix Systems (CTXS), Expedia Group ( EXPE), Liberty Global (LBTYA/LBTYK), Take-Two Interactive Software (TTWO), and Ulta Beauty (ULTA).

Investors who are benchmarked to the Nasdaq 100 must buy those stocks being added and sell those being deleted. As passive investing has grown in influence, the sums invested — and the amount of trading that occurs around the rebalancing — has grown considerably.

The Invesco QQQ Trust (QQQ) is the fifth largest ETF in the U.S., with roughly $150 billion in assets under management. The Nasdaq 100 Index is also a benchmark for a vast array of additional financial products such as options and futures.

Because of its size, indexers tied to the S&P 500 are expected to buy roughly $80 billion worth of Tesla to include it in the S&P 500, which means issuers will have to sell $80 billion of the remaining stocks in the S&P 500. This alone would be by far largest rebalancing in S&P’s history:  The prior record of $50.8 billion was in September of 2018. Tesla will likely be roughly 1% of the S&P 500’s market capitalization after its inclusion.

All of this trading — and money — sets up a precarious game of cat-and-mouse between the people who need to buy and sell stock (those who are tied to the indexes like ETFs and mutual funds) and those who can buy from or sell to them (the brokerage community).

“The goal of indexers is to buy Tesla at the close next Friday, and to sell the other companies at the close,” Howard Silverblatt, Senior Index Analyst at S&P Dow Jones Indices, told me.

This, Silverblatt says, puts indexers at odds with the trading community:  “If you are a trader or an investor, your goal is to buy or sell to the indexers at a profit.”  To make sure they will have the right balance of stocks, issuers often will end up making agreements with brokerage houses to deliver the stock they need to buy or sell on the trade date.

“The indexers pay a fee to the trading community to ensure they can get at least a portion of the stock they need,” Silverblatt noted. ”It’s all part of the cost of doing business.”

On a fundamental basis, this tsunami of trading should not change prices, since there is no change in the business of the companies listed.  However, there are significant changes in supply and demand brought about by index inclusion or exclusion, and that can and does influence prices.

And that is what makes these events a bit nerve-racking, particularly when you are dealing with something as big as Tesla, and a bit uncertain.

“Truth is, we don’t exactly know what will happen,” Silverblatt told me.

Ben Johnson, head of global ETF Research for Morningstar, says the key takeaway is that formerly obscure index providers are now major players in determining who owns what in the investing world.

“These index providers are much more than just index providers–they are effectively portfolio managers,” Johnson told me. ”They’re not asset managers, but they are determining where the money is going through their decisions about who goes into and out of these indexes.”

As a result, the index committees for the major providers — whether they are for S&P, NASDAQ, FTSE, or MSCI — have become extremely influential:  “These index committees have become one of the largest discretionary asset managers on the planet,” Johnson told me.

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