A story has shaken the investment world in recent days. S&P’s Index Committee announced that it is removing TSLA from the S&P 500 index. Ellon Musk is furious and it is firing a wave of populist comments. So are you interested why he is so furious? Maybe there is something very precious if a stock can categorized as “index stock” (member of stock market index). Here we bring our research skills to answer why Mr. “Iron Man” is so mad and is there really a difference between index and non-index stocks.
Stock market index is a collection of assets that is aimed at representing certain characteristics in the market. Indices can vary from broad market, sectoral, based on styles etc. For the sake of simplicity in this article we will focus on broad market indices that are aimed at showing the performance of the entire market. Initially indices were created to reference performance, so not to track the entire market you have a available tool that does it for you. The absolute most famous example is of course S&P 500 Index that is used as a reference for the entire US market and sometimes even the global market.
As everything in the stock market, indices are comprised of individual stocks. There are rules which stocks to be included in given index. Usually it is based on market capitalization, volume of trading etc. and at every X periods of time the index is being refitted with new stocks who answer those rules and some of the existing members are dropped. In essence this is a portfolio of stocks that is build following some rules and it is rebalanced from time to time. This is why often indices are used as proxy for the benchmark portfolio.
Existence of indices leads to situation where we have stocks that are members and a bunch of other stocks that are not and are considered candidates. In this article we check one very important question: is it beneficial to the investors to focus on index stocks? If the answer is yes then this means we have found yet another distortion of the modern financial markets, but importantly we can say to investors that they should invest in stocks that are members of S&P 500 and not look beyond it.
The idea that index stocks behave differently from non-index stocks is derived from long and painful observations of the stock market. More often than not we see how certain stock is boosting its performance right after becomes member of S&P 500 or some other index. For example TSLA in the year prior to its inclusion of S&P 500 had (~5% monthly return, 21% monthly risk, resulting in 0.25 Sharpe ratio), after it was included on November 17th 2020 the performance following year drastically improved: average monthly return over next 12M was 9%, the risk was 18% and the Sharpe ratio doubled to around 0.50).
Our own research
Our testing is based on the stocks available to trade from Revolut non-premium account and the sample has 1086 stocks. From those we market 504 that are current members of S&P 500 and consider them “Index stocks”, so the rest are labeled as “Non-index stocks”. Our research has 4 sections. First, we consider the relative performance of EW (equally-weighted) portfolios of all index vs. non-index stocks. Second, to dig deeper we measure the current fundamentals between the two groups. Third, we run risk-factor analysis and examine the exposures of each group against well-known risk factors. Finally we propose few reasons that can explain our empirical results.
For every investor the most important thing is return, so we are starting here to see if there is a significant difference between the two groups for their return characteristics. Also it is important to check what are the relative risks for each group. As our hypothesis is that index stocks perform better we are testing whether there is a premium of index vs. non-index EW portfolio. Next chart shows the risk and return stats of the two groups:
Fig.1 Premium of index vs. non-index stocks
For the past 12 years we have average annual premium of 11% for the index stocks and also very significant reduction of risk with almost 6%. This brings to gigantic increase of Sharpe ratio (Return/Risk) of 0.7 which is almost incredible. So basically by only investing in index stocks you boost your performance by 0.7 cents for every dollar of risk taken. Additionally we see that the spread between the two EW portfolios has been steadily rising since 2010. The gap is getting even bigger in recent years, but mostly because of increased volatility. This is evident on the bottom chart where we can see that since 2020 the volatility of the spread has been dramatically increased.
Overall we can conclude that there is a quite a significant outperformance by index stocks. However we are curious and in the investment world it is always better to know where numbers come from rather than just trust them. So in next section we will see are those stocks really of better quality.
On chart 2 you can see the actual return characteristics of each EW portfolio. So the spread that was discussed is pretty significant and the boost of the performance that you will get is quite large an improvement. Also here we show the 4 most important fundamental aspects of the two groups.
Fig.2 Risk/return characteristics and fundamentals
Given that most S&P 500 is based on largest companies it is logical that the median size of index companies is a lot bigger (28B) than non-index. This has one very crucial implication: index companies are mostly large-cap stocks, while non-index stocks are almost always small-cap and this is important when it comes to risk factors.
The two market fundamentals give us a real surprise. Assuming that non-index stocks are small, high-growth stocks, we would expect that their P/E and P/B to be higher, since their expected growth should be higher, But it turns out that S&P 500 companies have 4x bigger P/E ratio and 2x bigger P/B ratio. Of course this is current picture and it is subject to deviations but such a spread is so obvious and can’t be overturn easily. So here is where the distortion comes in: it seems that investors are rewarding the earnings of index companies a lot higher, basically they are putting 4x more money to obtain $1 of earnings from an S&P member. This is strange and not in accordance of traditional investment theory so we would need to explain it later. Also this provides an idea of the overall outperformance that we saw in previous section. If two companies earn $1 of earnings, the one that is in the index will get 4x more return for this. If indeed there is such a phenomenon it is worth to dig a little deeper and examine the two groups from a lot of different dimensions to find what drives each of them.
Different risks (exposures)
Factor exposures can give better insight into what exactly drives the difference performance of index and non-index stocks. First we get monthly returns of all 1084 stocks in the sample, we also obtain the monthly returns of 8 widely-used investment factors. Then we run monthly multiple regression to find the factor exposures of each of those 1084 stocks. Last step is to aggregate the exposures of each of the two groups (index and non-index) using the median. As you may have noticed we are using the median estimate across the entire article, this is because we want to remove the impact of any outliers. The results are plotted on chart x:
Fig.3 Median factor exposures
It is little surprising that non-index stocks have higher exposure to changes in the general market movement (0.79 vs. 0.63). Possible explanation is that investors in smaller, riskier stocks tend to be more influenced by global trends in investing and correspondingly react much quicker and volatile. On the other hand there are no surprises in the Fama-French factors – value and size. Index stocks have huge exposure to the value factor, as most of those stocks are entirely value-focused, while smaller non-index stocks are generally growth stocks. The same with the size factors, logically smaller, non-index stocks have huge exposure (1.21), while bigger, index stocks are much less impacted by this factors. The story extends to the Quality factor and with no surprise we see that index stocks are much more exposed to it, which means those are generally more quality stocks. For the momentum it is pretty much the same, as non-index stocks logically are more influenced by their momentum rather than larger index stocks. Another important factor to consider is the exposure to VIX (volatility) and we see that non-index stocks are indeed riskier in relation to the index stocks.
Moving to the two non-stock factors (Term spread and global minimum risk) we notice that they give us information regarding which economic trends impact the both groups. Non-index stocks are obviously more influenced by uncertainty in the economic conditions. Rising bond spread and level of minimum risk both impact positively the non-index stocks. This means that in time of economic prosperity investors try to diversify their portfolios by looking outside the index and trying to get exposed to different kinds of risk.
It can be concluded that non-index stocks are riskier, while index stocks are generally value and quality stocks. This makes it interesting when considering the higher P/E ratio of index stocks. Also we can say that in times of economic prosperity non-index stocks do get attention from investors, but are still terribly underpriced relative to index stocks.
Why it is happening?
Similar phenomenons usually can be explained from theoretical standpoint that one group have higher risk than the other and investors are rewarding those risks. However there is no clear theoretical evidence whether index or non-index stocks are riskier and should be rewarded. This makes it even more interesting. Actually this mispricing is due to modernization of investment. There are two huge reasons that explain why index stocks have been priced better.
Rise of passive investing
Passive investing is a type of investing where investors buys exposure to the whole market and doesn’t change anything, rather than the case in active investing where investors constantly try to predict better stocks. Passive investing is really fueled by the emergence of ETF (Exchange-traded-funds), an ETF is a instrument that offers you the same exposure as some underlying index. This makes passive investing really simple and very cheap, and this is why it is preferred by investors and has seen dramatic rise. However there is an implication! When passive investors buy ETF on S&P 500, they inadvertently choose to make a bet on index stocks only, because after all ETF provider will have to go out and buy those index stocks in order to construct the ETF. So the rise of passive investing has lead to mispricing of index stocks.
Accessibility to investing
In recent years thanks to new technologies more and more investors have easy access to trade and invest in the stock markets. It has become so easy that you can trade on your way to work in the subway from your phone. So all those new small and unprofessional investors need information to base their decisions. Since they are not really with financial background, those investors use news to base their trading on. However it is noticeable that in the news headlines we tend to see only big, large companies like Tesla, Microsoft, Apple, Google etc. So this type of stocks receives a lot more attention and trading volumes and are priced a lot higher. The thing is that index members are selected pretty much on the same attribute like size and volumes, so this leads to a lot more attention and funds that are allocated to those index companies.
The combination of those two factors leads to the observed mispricing of index stocks vs. non-index. However such mispricing is also an opportunity for investors. Knowing and understanding that index stocks tend to perform better now YOU can focus your investment decisions to index stocks only. This is why Ellon is so furious also, because if TSLA is out of S&P 500 this will lead for sure to a lot poorer performance by the stock and lost of wealth to Mr. “Iron Man”.
Link to research dashboard in Tableau: Here