As many people know, on Monday the S&P 500 Dow Jones Indices announced that Tesla will join the S&P 500, effective Dec 21. The car maker will be the largest company ever to be added to the index, after its (so far) 600% run up this year pushed the company's market valuation over $460B. Adding a company this big to the index has its own set of challenges.
Regardless, the addition of any company to the S&P 500, let alone one the size of Tesla, is a huge deal. There is over $11.2T of assets indexed or benchmarked to the S&P 500, with index funds comprising $4.6T of the total. At its current size, Tesla is expected to comprise over 1% of the index. That means shoehorning Tesla into the S&P 500 on Dec 21 will force, at least, $50B of rebalancing. And that's where the arbitrage comes in.
The old adage in finance, and life, is that there's no such thing as a free lunch (except for diversification). Expected returns are proportional to risk. If there happened to some risk-free arbitrage opportunity it would quickly be bid away. But due to structural and behavioral reasons, sometimes near risk-free opportunities can exist.
Pioneering quantitative strategist, Rob Arnott of Research Affiliates has shown that companies that get added to the index are typically 'hot' companies with lofty multiples, while companies that get removed on a discretionary basis (i.e., not due to M&A or other corporate actions) are usually deemed unimportant and are generally cheap. Arnott estimates that there is about a 3-to-1 ratio in valuation multiples between the added and deleted companies. In effect, when passive indexes (and some active investors) rebalance in response, they are buying high and selling low. Testing data from 1989 to 2017, Arnott found that
over the following 12 months, deletions, on average, outperformed discretionary additions, by 23%!!
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