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Why Do Morningstar Equity Indexes Include Tesla?

When benchmark construction matters

We recently received the question: “Why do Morningstar equity indexes include Tesla?” Our initial reaction: “Why wouldn’t they?” After all, the electric vehicle maker’s market capitalization as of early November exceeded $400 billion, making it one of the 15 largest stocks in the U.S. Shouldn’t indexes designed to represent the equity market hold one of its largest constituents?

The question is justifiably on investors’ minds because the committee that oversees the S&P 500 has yet to add Tesla. More than $10 trillion in assets are benchmarked to that index—from active U.S. equities managers who use it as a measuring stick to passive investments that track it. The S&P 500 is even cited as a barometer of national economic health. Index composition doesn’t typically attract much attention, but Tesla’s meteoric stock price appreciation makes it hard to ignore.

Different index-construction rules explain the divergence. Morningstar’s equity market indexes, like many others, include all securities meeting stipulated criteria. Constituents are weighted by their market value. There are no requirements for profitability and no discretionary input into membership. The Tesla case highlights why it’s important to research indexes used for benchmarking and tracking, as Morningstar Manager Research analysts do when they evaluate passive funds.

What’s an Index for Anyway?

Since the 19th century, market indexes have served as gauges for investors. Most fundamentally, they are meant to define “the market,” or the opportunity set for a particular asset class. They have taken on immense utility, helping to measure performance, highlight risk and return drivers, and assemble portfolios. Even as indexes have increasingly come to underpin passive investment strategies, the job of a traditional beta benchmark remains to reflect an investable universe.

Morningstar equity indexes pursue the goal of representing the market by including all companies that meet requirements of liquidity, geography, and size. Following clear and published rules, the indexes exclude certain classes of securities—limited partnerships and listed funds, for example. Stocks meeting basic criteria are then weighted by market capitalization, adjusted for free float. There’s no discretionary input. Constituent count is flexible so that the indexes reflect a consistent proportion of the investable market. After all, market dynamics change. Since the 1990s, the number of public companies in the U.S. has fallen from 8,000 to fewer than 4,000.

While several other market indexes follow a similar approach to Morningstar, not all do. Some indexes are governed by committees that exercise discretion over inclusion. As Morningstar Manager Research notes, the committee-based approach used to construct the S&P 500 affords “greater flexibility than more-rules-based mechanical indexes that follow rigid guidelines. However, it reduces transparency.” Indeed, investors have been left guessing why Tesla didn’t make the cut.

Why does this matter? Tesla shares are held by thousands of managed investment strategies the world over, leading to a disconnect between the investable market and an index meant to reflect it. Owning Tesla has advantaged active funds whose benchmarks exclude Tesla. It has boosted the returns of passive strategies tracking indexes that include Tesla relative to those that don’t—albeit not by a large margin. Of course, if Tesla declines, those rankings will reverse.

Do Your Index Homework

In our view, investors pay far too much attention to brands in index selection. Suitability should be the key criteria when it comes to picking a benchmark. For a passive tracker, what’s important is that an index delivers the desired exposure. But how many investigate index-construction rules? Benchmarking decisions are often made by pursuing the path of least resistance.

Ultimately, there is much to gain by more competition in the field of benchmarking. Asset managers paying rising index licensing would benefit from industry disruption. So would the investors who often end up paying for those fees in the form of higher fund expenses. Most indexes representing the same market segments are interchangeable and don’t justify premium pricing. But there are distinctions between indexes. The case of Tesla demonstrates that index-construction rules can matter.

Dan Lefkovitz is a strategist for Morningstar's Indexes group.

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