Here's how much 5% invested in Tesla would have added to index fund investor return

The index fund has thoroughly disrupted the role of active stock pickers in the market, but in an era of accelerating disruptive business models across sectors of the economy, stocks like Tesla remind investors that they still need to make some conviction bets to generate above-average returns.

Tesla will begin trading next Monday morning, as part of the S&P 500 index through which most investors now get their core U.S. large-cap market exposure. Many index fund investors may be wondering what it will mean — both the potential gains and risks — for their portfolio to get a dose of Elon Musk’s high-flying electric vehicle and renewable energy company after its huge run in 2020.

The answer: Not all that much of a difference. At the relatively small weighting that Tesla will have in the index, even as one of its largest holdings, Tesla will not hold outsize influence over an index fund investor’s return whether it goes up or down by a lot in any given year.

The Tesla S&P 500 inclusion event, by one measure, is a sign of just how powerful index investing has become — it is the biggest stock addition ever and it is being done all at once. But as Tesla enters the S&P 500 after a decade as a public company and an astronomical total return since its IPO price of $17 in 2010, index fund investors may also wonder what they have missed out on already.

if an investor had put $5 of every $100 invested in an S&P 500 index fund into Tesla shares at the beginning of 2020, their return would have increased by roughly 31%, according to DataTrek Research, based on performance through last Friday, Dec. 11.  

The S&P 500 price return year-to-date through Dec. 11 was 13.4%. Tesla’s price return YTD through the same date: 634.5%.

That means $100 invested in the S&P 500 at the start of the year would be worth $113.40, not including dividends, which are worth less than $2 of additional return.

If an investor put $95 in the S&P 500 at the start of the year and $5 in Tesla, the index would have risen to $107.73 and Tesla to $36.73, for a difference of $31.06 (or 31 percentage points).

Amid a frenzied IPO market that has sent disruptive companies public and raised concerns about a repeat of the dotcom crash, there’s a lesson in the Tesla gains — but it is not the one about taking too much risk, or the stock market as a casino where the house always wins, or regretting forever having missed out on Tesla. It’s a lesson about having the conviction to take just a little risk. The $5 bet shows that you don’t have to bet big, or bet all your money, to benefit from having conviction in a disruptive business model.

Index funds, which are hard to beat for most stock pickers over the long-term, are not about to lose their place as a core portfolio ballast. But today’s top index fund holdings, the ones that dominate the S&P 500 weighting — Apple. Alphabet, Microsoft, Facebook — all made investors a lot of money before they were included in the index. 

This has been the biggest year for IPOs since 2014, and more disruptive companies are coming into the public markets. Nick Colas, co-founder of DataTrek Research, says this means investors should think about where they might put a $5 “carve out” of their portfolio in 2021. 

The underlying theme that Colas teases out of the Tesla trade is in evidence within the existing S&P 500 itself as well. He noted that the S&P’s above-average returns over the last decade relative to other global stock markets is because of a handful of disruptive tech stocks: Amazon, Microsoft, Apple, Alphabet and Facebook, among them.

Warren Buffett, who has warned for years it gets harder and harder to beat the index, is now the largest shareholder in Apple through his firm Berkshire Hathaway. Berkshire did finally invest in Amazon in 2019, though it was not Buffett himself, though he has called his reluctance to invest in Amazon much earlier “stupidity.” And after having never bought an IPO in the history of Berkshire Hathaway and recommending individual investors avoid them, Berkshire Hathaway finally bought into a deal this year, Snowflake, the largest software IPO ever.

“It is important to have a huge backlog of ideas in the system and if just a few work, you generate the above average returns,” Colas said. “The last decade is a fantastic case study of what drives returns. As an investor you should love the fact that we have all these new names in the system because a few will work. Tesla is the ultimate case study in why we need those names,” he said. 

Tesla may go down, a lot, and at any time. J.P. Morgan continues to have a sub-$100 price target on the stock — though it has been on the wrong side of the call for years now — and Elon Musk recently warned that if costs aren’t kept under control to maintain profits, investors will treat the stock like a souffle under a sledgehammer.

A similar warning goes for the IPO parade as well. As the potential payoff associated with recent gains seeps into the psychology of investors, there is the potential for it to go very wrong.

Three of the 10 largest tech IPOs ever have occurred this year, and with companies going public later and later in their histories, unlike in the era of Amazon and Google, much of the value is already embedded in stocks before they enter the public market. Airbnb and DoorDash both sank on Monday after huge IPOs. Some IPO experts worry more pain is coming in what looks like it could be an IPO bubble.

And not all investors have sophisticated Wall Street models as their source of conviction.

“I had clients eight months ago saying they were buying Tesla because they were seeing more in their neighborhoods,” Colas said.

That is a correct observation about mass adoption of new technology, but Colas also stresses that the big conviction can be executed using a small bet. The point is not to have a huge overweight position in any stock, but to remember that just 5% can make a big difference.

“It’s the return power of picking the right name. I’m fine with index funds as a cost strategy, but these are the payoffs that are possible from stock picking,” he said. “You don’t have to put a lot of capital behind these bets. You didn’t need to put a lot of money to work in bitcoin to make it work in 2017, or after it fell apart,” he added.

Bitcoin has recently traded at a new record price.

“The classic problem for the individual investor is sizing,” Colas said. “How do you size a position. That’s what institutions are thinking about all the time. You don’t have to put a lot in.”

And if an investor chooses the wrong name?

Buffett said in a speech ahead of the dotcom bubble bursting that it is easier to find all the losers who bet on the transformations wrought by industries like autos and airlines than the ones who got rich. “Sometimes, incidentally, it’s much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money. But there was one obvious decision you could have made back then–it’s better sometimes to turn these things upside down–and that was to short horses.”

But if the conviction is high and the bet is small relative to overall market allocations, and the risk can be stomached, it won’t crush a portfolio.

“If you’re wrong, you’re still up 9% return,” Colas said, calculating how much the 5% taken out of an index fund would reduce the overall return of the core index fund. That is close to the long run average for stocks of 10%.

As Tesla heads into the S&P 500, the Wall Street analyst says its 2020 has shown how stock indices underweight disruption. “If you want to be equal weight society it takes a long time and today the indices are overweight the internal combustion engine. Overweight the disrupted and underweight disruptors,” Colas said.