Inflexibility in Investing Will Cost You
The big money is not in the buying or selling, but in the waiting.
You may have seen Singapore’s ‘Emerging Stronger Together’ 2021 budget as announced by DPM Heng Swee Keat. It came with a slew of new economic initiatives and measures, with a large section devoted to “building a sustainable home for all” that focused on Singapore’s green initiatives. Electric vehicle enthusiasts would be heartened by the proposals to reduce the ownership costs of carbon friendly vehicles. On top of that, Tesla — an American electric vehicle and clean energy company also announced plans to start selling their vehicles in Singapore.
For investors familiar with Tesla stock, S&P Dow Jones Indices announced late last year that Tesla would be added to the widely tracked S&P 500 index. The news stirred up a lot of attention as Tesla would be the largest company to ever join index at nearly $600B valuation. When the announcement was made on November 16, Tesla’s stock price jumped 8.2% in a single day and continued to post strong returns, closing December 18 (the date of addition to the S&P 500 index) up 70.3% (this is seen in the chart below). This made the index return of 2.3% over the same period look pitiful in comparison.
While Tesla’s stock price wowed investors ahead of the company’s addition to the S&P 500, the pattern quickly reversed: the stock climbed 13.9% over the five days ending with its index addition on December 18 yet slumped 6% over the subsequent week. What does this mean for investors?
Given the rise and interest in passive investing, a lot more investors have been investing in Exchange-Traded Funds (ETFs). ETFs are a type of asset involving a collection of securities that can be bought and sold on the stock market, typically tracking an underlying index. They are excellent vehicles to gain access to the market at a relatively low cost, allowing you to purchase a diversified basket of securities in a single product (though how diversified, depends on the characteristics of the individual ETF itself).
However, there is a downside to the way ETFs are managed and how they keep their costs low. ETFs undergo rebalancing once or twice a year when the index they track reconstitutes, they then have to mirror reconstitution by purchasing and selling securities based on changes to the index. As such, with regard to Tesla, many index funds had no choice but to buy the stock at the high price listed on the day it was officially added to the index. This lack of flexibility results in buying and selling at sub-optimal prices, translating to reduced returns and a higher ‘cost’.
ETFs generally have to buy on market close — the day the stock is added to the index. The price of Tesla spiked into the market close as the demand for the stock shot up. Thus, ETFs will often buy the added stock at its peak. Stocks that are added or deleted from indices (and hence ETFs) are associated with unusually high trading volume. This translates to a higher volatility for the price of the stock.
The chart above shows trading volume in stocks added to or deleted from the S&P 500 on reconstitution day compared to the trading volume of the same stocks in the days before and after. This is tracked across reconstitution events over the 2015–2019 period. The significant rise in Tesla’s stock price ahead of its addition to the S&P 500 is consistent with this pattern.
The diagram below shows a broader picture of prices.
As you can see for the S&P 500, the prices of additions and deletions start to move higher and lower respectively when compared to other stocks around one month before the reconstitution day. This movement suggests pricing adjustments can occur well before the reconstitution day for those indices as investors are trying to arbitrage the opportunity. ETFs will inadvertently be paying a much higher price every time they add in a stock, and selling at a much bigger loss when they remove a stock. Using Tesla as an example we can see how the lack of flexibility in a passive approach leads to diminished returns from buying at a sub-optimal price.
There is a better alternative — a daily process that maintains a consistent focus on stocks with higher expected return and spread turnover across the entire year, with flexibility at the point of trade execution across stocks and quantity. This allows investors to incorporate information about liquidity and trading costs and avoid the cost of demanding immediacy from the market. A daily investment process also allows for the incorporation of short-term information about expected returns that is relevant over days or months, such as momentum and information from securities lending fees. This would allow the buying and selling of stocks to happen at more opportune times.
In addition, daily portfolio management can further enhance investment outcomes by maintaining a consistent and accurate focus on the desired long-term drivers of expected returns and continuously balancing tradeoffs between premiums, costs, and diversification. This is what we do.
This method of investing is fully incorporated in our Everest portfolios and to a large extent in the equity allocation of our VaR portfolios to give our clients and investors the highest probability of investment success.
