In what’s perhaps the most anticipated index rebalance in recent memory, Tesla is set to enter the S&P 500 Index by end of day Dec. 18. The addition is huge in nominal dollar terms; in the S&P 500 security weighting rejiggering that it will require; and in the massive wave of trading it will unleash as the passive investing world tied to that benchmark follows suit. It will be a trading day to remember, and one that Rich Lee, head of program and ETF trading at Baird, is preparing for. He shares his expertise on how this type of trade should happen, how it impacts ETF investors, and how it ultimately depends on a “robust ecosystem” to work smoothly.
ETF.com: Give us an overview of your day-to-day role at Baird as head of program and ETF trading. What’s “program trading”?
Rich Lee: I help all our institutional trading customers trade and implement program and ETF strategies for trading. For instance, if you’re a money manager who's indexed to the S&P 500, you may buy SPY [the SPDR S&P 500 ETF Trust], or you may be actually buying a basket and holding the underlying. If you're trading that basket of 506 stocks, that's actually known as a program trade.
When you have to rebalance to get your weights back if a stock has had a tremendous price appreciation—which causes it to have a bigger weight—you’d need to take the cash proceeds and buy a bigger weight, and rebalance across all your funds so that you'd be doing a buy and a sell. That would be a program trade as well.
ETF.com: In your part of the ecosystem, the upcoming addition of Tesla to the S&P 500 is a huge event. What's ordinary about this kind of addition to an index? And what's extraordinary about it?
Lee: What's normal about it is that it’s happening as part of a normal quarterly rebalance for S&P-related indexes and S&P-related ETFs and funds. Every quarter, there’s a massive rebalance that happens in all these ETFs and the index. Names get deleted because of a takeover, so a name needs to be added to take its place; a name may have underperformed, which causes you to need to buy for the index, or vice versa.
That all creates a pretty big and significant trading event. If you think about how much money is indexed to S&P 500 index funds and ETFs, there are a lot of money managers who’ll need to do this trade. That’s what’s not unusual about this Tesla event. It's pretty standard that quarterly additions and deletions are named for the S&P, and people will need to reweight their funds and the underlying stocks for ETFs that may track the S&P 500.
What is unusual about Tesla is that, first, there's been a lot of excitement around it given the history of the stock, and people have been tracking it, waiting for when it actually would meet all of S&P's criteria for eligibility for the index. The last criteria they were waiting for was profitability, and it met it, so there's a lot of excitement and speculation. It didn’t get included in the September rebalance, but as we know, it’s being included in the December rebalance, so there's a lot of buzz around it.
The biggest thing about it is the sheer size of it. Because of the market cap of Tesla, because of where the stock's trading, it's going to go into the S&P as one of the largest weights and largest adds from a notional dollar perspective.
What's not unprecedented—but a bit unusual—was that, given the size of this Tesla addition, there was some discussion among S&P where they did a consultation among users and said, “Because Tesla's so big, and it's such a big trade, do we want to include it in the index in two pieces, to reduce some of the risk and the complexity of the balance sheet requirements? Or do we just want to do it all on Dec. 18?” That’s a quadruple witching, and the date of the regularly scheduled S&P rebalance. They ultimately decided to do it all in one shot on Dec. 18.
ETF.com: So, Dec. 18 is the big day?
Lee: Quadruple witching and quarterly rebalances typically occur on the third Friday of the quarter; so, September, December, March and June. You have to trade it on the 18th to be part of the index, but a lot of times they word things to say it will be included into the index as of the opening of Dec. 21.
ETF.com: To clarify, when you talk about “quadruple witching” you’re referring to the fact that there's all sorts of futures and options contracts, and all of them expire at the same time on a bunch of stocks, plus index rebalancing, so it's just a day of massive trading volume?
Lee: That's right.
ETF.com: If you're a passive ETF manager, is there a window to adjust S&P 500-linked ETFs to this change in the index—before or after the event—or are we going to see it all go down on Dec. 18 and 21?
Lee: In general, indexes and pure S&P-benchmarked ETFs have a mandate where they cannot have a certain deviation from the tracking error. So, they’re probably not going to trade it in advance because they need that closing price to mark the funds and to mark the closing prices on the 18th. In general, you’ll see the bulk of ETF providers and indexers be held to the close, trading on the close, on the date of the index event.
ETF.com: There seem to be many folks concerned that, after the year that Tesla has had, passive investors are now going to be forced to buy Tesla at the top. There's no way to work around that, right? You're going to have to buy at the share price that day.
Lee: Correct. Because the S&P 500 is a market-cap-weighted index.
ETF.com: Is there any concern about liquidity in a day like that day?
Lee: In general, one of the reasons people look toward this like a quadruple witching and rebalance days as a big trading day is that liquidity begets liquidity. There are good opportunities for people who are looking for liquidity, whether they're looking to buy or sell. There's always somebody out there doing something. From that perspective, quadruple witching days are very good opportunities to source liquidity.
But to your point, why wouldn't Tesla stock just run another, say, 25-50% given that everybody has to buy it? That's where having a robust and dynamic market comes into play, because there are market participants, whether it be proprietary traders, hedge funds or prop shops whose job is to look for these announced index changes and trade them ahead of time, and hopefully accumulate a position in advance of the index and be suppliers of liquidity.
The sell side is a liquidity partner in this endeavor. If we look at an index fund that cannot deviate, and it cannot trade early, if you don't have the sell side there prepositioning or accumulating position, you may have that scenario where the stock just runs uncontrollably to the upside. You want a robust ecosystem.
People have been trying to play this trade since the summer, when they thought it was going to be included into the S&P 500 in September, which is why, when it didn’t get announced, you saw the stock sell off. Then the game starts over again.
ETF.com: When it comes to ETF trading, we often assume the plumbing's going to work. But you see folks with dire warnings ahead of an event like this, saying things like, “Watch out on Tesla, because things can go wild.” What qualifies as “wild” on a day such as a rebalance day where Tesla gets added?
Lee: I think when people say “can go wild,” usually when they refer to extreme volatility—extreme price dislocation—things can really move out of whack one way or another. That can be anything as simple as an outsized position that somebody's trading that wasn't anticipated, so there's insufficient demand, to a fat-finger human error, to a system error. But these are things people are always on the lookout for.
From our perspective, we always want to be sure that our technology's working. That’s top of the line. And that all our risk metrics and risk checks are in place, and we're able to transact high volumes of business. We also have risk management systems in place to make sure we're protecting our customers and ourselves.
Contact Cinthia Murphy at [email protected]