What Tesla's entry into the S&P 500 means for portfolios

The historic addition on Friday of electric vehicle maker Tesla (TSLA) to the S&P 500 Index can and will be analyzed in several ways, but for anyone currently invested in any fund tracking the popular benchmark it effectively amounts to buying high.

Beyond the unprecedented significance of the index reconstitution that represents the single largest addition in the history of the S&P 500, and among the largest equity trades in the history of the stock market, there is the reality that the barely profitable technology company is trading at a price-to-earnings ratio of 1,273 after a 2020 stock price gain of nearly 700%.

For some perspective, Apple (AAPL), which has gained a mere 78% this year, has a trailing P/E of 38. The S&P 500 Index is up 15% over the same period.

“I’d be hard-pressed to argue that you’re getting a bargain here with the Tesla addition,” said Morningstar’s global director of ETF research Ben Johnson. “We have a one-star rating on the stock at the moment, indicating that we think it’s quite overvalued.”

To be clear, valuations are of minimal consideration when it comes to most index reconstructions. In the case of the S&P 500, what matters is Tesla’s whopping $630 billion market capitalization, making it the seventh-largest company in the index with a 1.5% weighting.

“With Tesla’s volatility, it will impact the index one point for every 11 points the stock moves,” said Paul Schatz, president of Heritage Capital.

Todd Rosenbluth, director of mutual fund and ETF research at CFRA, said in addition to impacting every index-based fund tracking the S&P 500, there is a ripple effect across other stocks in the index.

“This is not a one-for-one trade since more moderately sized stocks like General Electric (GE), Coca-Cola (KO) and Intel (INTC) will likely be trimmed to make room for Tesla,” he said. “In addition, hundreds of active mutual funds use the S&P 500 index as their benchmark and will need to determine if they want to take on benchmark risk by owning no shares or build a small position. This is the case also for advisers that build their own single stock portfolios for end clients.”

Chris Chen, founder of Insight Financial Strategists, described Tesla as “the next shiny object,” and said “this might be a reason to underweight the S&P 500 in client portfolios.”

“The price performance of Tesla is a little out of whack and is not sustainable,” he said. “If you’re going to be in the index that’s how it is, but I haven’t really come to terms with that yet.”

For those concerned about Tesla’s general impact on the S&P 500, there are always broader index choices. Rob Greenman, lead adviser and partner at Vista Capital Partners, cited the Vanguard Total Stock Market Index ETF (VTI) as a viable alternative.

“At the beginning of the year VTI held about four million shares of Tesla, and as of June 30, that holding had increased to about 4.2 million shares,” he said. “So, folks who owned the whole market not only participated in the meteoric rise, but also increased their proportional holding in this super stock.”

Vance Barse, founder of Your Dedicated Fiduciary, is also in awe but not necessarily afraid of Tesla’s meteoric valuations.

“I’m hesitant to jump on the bandwagon, but the perma-bears have been wrong about Tesla for so long,” he said. “I suppose adding it to the S&P could be a tailwind for index investing, but only time will tell.”

In addition to the immediate impact on the funds tracking the S&P 500, there is also the bigger question about Tesla as a company with such sky-high valuations.

“Tesla is the biggest electric vehicle producer, its valuation is more than triple the valuation of Renault-Nissan, Volkswagen, and Hyundai-Kia combined, which are the second, third and fourth biggest electric vehicle producers and have triple the market share of Tesla,” said Leon LaBrecque, chief growth officer at Sequoia Financial Group.

“You could sell Tesla and buy the nine largest car manufacturers in the world and have money left over,” he added. “It's kind of fun to divide [Tesla’s market cap] by the 425,000 cars they’ve built and see how much the investment per car is, and then compare that to Toyota or General Motors.”