Theres no template to follow for Vanguards two dozen US traders plus a team of analysts who work on keeping transaction costs down when it comes to efficiently handling a stock as big and volatile as Tesla. Nor is it easy to predict the ripple effects in the overall market.

A shift in the index composition could be announced any time. The addition theoretically could happen along with the departures of E*Trade Financial or Tiffany & Co, which are being acquired, or as part of a routine quarterly rebalancing in September.

Index funds may get as few as a couple days notice of the switch. So they need to decide if they should start buying before the addition, the day the stock is added, or afterwards. Picking which approach is not as simple as it sounds. While Teslas stock may be bid up by traders trying to take advantage of demand from indexers, other investors may treat it as what OReilly calls a super liquidity event. That is, longtime Tesla shareholders who are looking to trim positions may try to get out when they know index funds have to buy.

The two kinds of investors could cancel each other out. There are all sorts of crosscurrents, OReilly says. He says hes confident Vanguard will be able to handle the switch without a big tracking error that is, a dislocation between the performance of the index and the funds that follow it.

Like many things about Tesla chief executive Elon Musk, his companys path into the S&P 500 is unconventional, which explains how Tesla became the gorilla in the room for the index fund crowd. Investors simply believed in the Tesla story enough to bid the share price into the stratosphere despite a record dotted with more quarterly losses than profits.

The S&P 500 is weighted by market capitalisation and the most highly valued companies take up the largest share of the index. If that were the only standard, Tesla would have qualified a while ago. The threshold to be added is a market value of a little more than $US8 billion.

The committee that decides the membership of the S&P 500 is keeping mum about when or even if it plans to add Tesla.

Companies who meet the eligibility requirements are not automatically added to the index, an S&P Dow Jones Indices spokesman said in an emailed statement. They join a pool of other eligible candidates and are considered for inclusion when an opportunity presents itself, at which point the index committee takes several factors into account, such as sector balance and size representation.

When figuring out how to weight companies in the index, the S&P adjusts their value to reflect the number of shares available for trading. Using that standard, Tesla would probably be the 17th-largest company in the S&P 500 if it were included now, with an index weight of about 0.8 per cent between PayPal Holdings and Pfizer.

One of the largest additions to the benchmark in recent history occurred a decade ago with Warren Buffetts Berkshire Hathaway, which at the time had an adjusted market value of $127 billion, far less than Teslas today. But it represented a bigger weight in the index then.

While indexers strategise about how to handle this shake-up to the passive investment world, traders with a more active approach will try to figure out how to profit from price swings created by the potential announcement. The trade would basically be; buy Tesla, sell everything else, and youd start to see that in the market, says Steve Sosnick, chief strategist at Interactive Brokers.

Still, its possible that expectation is priced into Teslas shares after a gain of as much as 293 per cent this year. A working paper posted by the National Bureau of Economic Research in July found that stock pops linked to the announcement of index inclusion have gone away, and the lasting effect on price in recent years has been downwards.

Since Tesla reported earnings, its shares have fallen 6.6 per cent. Firms included in the index perform extremely well in the year before they are included in the index, says Ren Stulz, a professor at Ohio State University and one of the papers authors. Our results would also imply that getting into the index would not lead to another boost in Teslas stock price.

Bloomberg Businessweek

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What will happen when Tesla hits the S&P 500 - The Australian Financial Review