Index Changes and the Potential Impact on Your ETF Portfolio

The great thing about ETFs and index tracking is that you own the entire index and that you benefit from survivorship bias. The good companies stay in the index, the improving companies get added to the index, and the weak ones drop off. The bad thing about owning the index is you own many companies that used to be strong and now, for whatever reason, they are weakening and dropping off. The transparency of how indexes are created is great for consumers, but in recent years it’s become a reason to front run the index provider.

There have been some high-profile stock splits in recent weeks that have had meaningful impacts on this idea of front running index changes and index inclusions.

On Jul 30, AAPL announced a 4-1 stock split, which will happen on August 31. This will reduce AAPL’s influence on a price weighted index like the Dow Jones Industrial Average by 75%. It will go from being the largest stock at 12% to the same as IBM at around 3%. Today AAPL has never been more expensive on a price to sales basis.

A stock split adds no economic value to the company at all. Are you better off exchanging a five-dollar bill for five loonies? Earnings do not improve at all. This is a strong sign of speculative froth.

Getting added to an index is important too. Index tracking funds like the S&P 500, are forced to buy the stock or sell it when an index change is made.

On August 10, TSLA announced a 5-1 split. It is estimated that index investors will need to buy close to $40 billion worth of TSLA when it gets added. The index announcement is expected some time around Sept 11, one week before any adjustments. It trades at 250x forward earnings and 1000x trailing earnings. At least they are making money, though most of it is government subsidies. Clearly this rally has nothing at all to do with fundamentals and everything to do with hype and froth.

The Dow has dropped 3 names from the index XOM, RYX, PFE and added CRM, HON, AMGN. The changes to the index have the biggest impact in healthcare and industrials. AMG replaces PFE in the sector, but PFE is the lowest price stock in the index. AMGN trades at around $250 and PFE is around $37, more than 7x the weight. Similar story for the switch from RYX to HON. HON is about $166, while RYX is about $62. But the interesting thing is AAPLs split, takes all the other stock weights up as it goes down 75%.

All these events have impacts on your portfolios for the ETF investors out there. It’s important to understand what’s moving the markets so that you can make a more informed buying/selling decision.

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