Passive investing was sold as the way to sit out the madness of crowds. Buy the index, pay almost nothing, own the market and let the stock-pickers exhaust themselves. For most investors, most of the time, that promise has been kept. But this June offered a useful reminder that the index is not always the neutral instrument the brochure suggests.
To accommodate SpaceX’s flotation — the largest in history, at roughly 95 times revenue for a loss-making company — the Nasdaq-100 shortened its inclusion waiting period to just 15 trading days. The effect, as Prof Adrian Saville of the Gordon Institute of Business Science notes, is that passive funds tracking the index had to buy “something like $14bn of the stock within weeks”.
This meant that millions of savers would “own a slice of the most expensive listing in history … not because they chose it, but because the index did, and the index changed its rules rather than miss the largest IPO ever”.
The subsequent fall in the SpaceX share price holds lessons for index investors.
The Tesla rehearsal
The speeding-up of a newly listed share’s inclusion in an index has precedent. When Tesla joined the S&P 500 in December 2020, index-tracking funds had to sell about $51bn of other holdings to buy it.
In that case, index funds bought near the top of the surge. It made only a modest difference to a diversified saver’s long-run outcome — Tesla was one position among hundreds — but it illustrates the mechanics: the tracker is the buyer who cannot say no, and the rest of the market can read its shopping list in advance.
The mechanics matter more as the machine grows. And it is growing. PwC reckons passive assets under management will increase by 10% annually, reaching $70-trillion by 2030.
None of this makes indexation unsound. It does mean the rulebook that directs those flows deserves more attention.
Far from a purely neutral, unemotional option, index investing is a human construct. Yes, trackers bring powerful guardrails that defend against the dangers of sentimental trading. But the index is only as sound as those who design its rules.
At heart, an index is a set of rules that guide decisions. These rules determine what assets enter the index, when, and in what proportion. Behind the rules are committees at the likes of S&P, Nasdaq and FTSE Russell. Choosing an index fund does not remove judgment from investing so much as delegate it to the rule-writers, who are as human as the rest of us.
Rules and rockets
Seven weeks after SpaceX’s listing — and less than a month after its index inclusion — how have things turned out for investors?
SpaceX began trading on June 12. The shares were priced at $135 in the IPO and opened at $150. It took just days for the price to surge above $200 and then fade. When the stock entered the Nasdaq-100 on July 7, it closed just under $150. By the end of July, the share closed at a fraction above $108. This week it is back above $130.
None of this is a case against index investing, which remains the cheapest and, for most people, the most sensible access to markets ever devised. In fact, this story highlights the benefits of index tracking. Investors with a sensible portfolio including the Nasdaq 100 benefited from their wise decision to diversify. Their losses were far more palatable than those who stock-picked Elon Musk’s rocket business.
Still, this episode holds lessons for index investors. The first is the importance of knowing what an index holds. “The label on the fund describes an intention,” explains Saville, “while the holdings describe a position. The two can drift surprisingly far apart.”
The second is to temper the assumption that indexation is immune to the allure of emotional investing. “The index is written, amended and [sometimes] fast-tracked by people,” Saville goes on. “June’s events showed that the fear of missing out can reach the rule-writers themselves.”
Finally, this is a reminder that sexy stocks are not always the ones with the best returns. “While the SpaceX IPO dominated everything from headlines to braai-side banter,” concludes Saville, “local government bonds were paying double-digit yields. That income is real and demonstrated. The fiscal risk is well understood — even if they aren’t putting satellites into space.”
The Centre for African Management & Markets at the Gordon Institute of Business Science conducts academic and practitioner research and provides strategic insight on African markets. Macleod is a founding member.
