SMCI: AI and March 18th Index Inclusion Fireworks

Our current income portfolios: 

DFMAP (Dividend Focused Multi-Asset Portfolio) 
TAC (Treasuries Across the Curve)
VWI (Volatility Weighted Income)

We were on Schwab Network Monday 2/26 and the ETF Prime podcast Tuesday 2/27. Links below:

Schwab Network: https://schwabnetwork.com/video/multi-asset-correlation-trends
ETF Prime: https://etfstore.com/arch-indices-yang-tang-spotlights-voi-absolute-income-etf/

There has been widespread criticism of the S&P 500 on a variety of issues. One of the main criticisms is the eligibility for inclusion and having a closed-door index committee making the final decision. If this was only used for informational purposes, it would not be an issue since informational use doesn’t cause market impact.

“The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.”

“Widely regarded” is a subjective term to say the least. Perhaps no bigger debacle has ever occurred than allowing Tesla to become the 8th largest company in the US market before being included in the S&P 500 in Dec 2020 (announced 11/18). There were a number of hedge funds that were long TSLA in Q3 2020 betting on inclusion and subsequently got stopped out. 

This set off one of the biggest rebalancing needs of index funds that track the S&P 500 directly and funds that benchmark to the index but don’t directly track it. With the sudden and abrupt nature of inclusion, these funds were forced to scramble and buy Tesla stock without any regard to price: a process we refer to as “index gamma.” 

A reputable index that tracks the 500 largest companies with a closed-door index committee would be better served not letting companies become this large before inclusion. Given the size of index funds, this is a disservice to investors everywhere and a great example of why the current generation of indices are arbitrary and do not serve investor needs. 

This is also a great example of why market-cap and equal weight indices do not serve an investment need unless you are specifically looking for a size bias. Investors are better served with risk-adjusted contribution to the portfolio. 

The S&P index committee seems aware of their shortcomings and are adding Super Micro Computers to the S&P 500 on March 18th. There are many opinions on SMCI, its valuation, and frothiness in AI names but the point of passive market exposure indices is to bypass these discussions and track market exposure. 

Key points:

• SMCI is currently at 50bn market cap, placing it around 0.12% of the index. 

• SMCI is replacing Whirlpool, a 6bn market cap holding. The index funds would need to sell approximately 0.10% of all other holdings to match the index composition. 

• SMCI and Whirlpool are switching places between the S&P 500 and S&P 400 Midcap indices which will offset some of the pressure. 

• It is estimated there are over 6trn of assets in funds that track the S&P 500 which means there is $7.2bn in demand from that. (Figures are from YE 2022 so likely it is 25% higher). This is partially offset by S&P 400 Midcap funds selling.

• An additional 6trn of assets use the S&P 500 as the benchmark which will create demand as these funds do not want to run significant tracking error versus the benchmark.

• 15% of SMCI is held by insiders and another 9.5% of shares short as of Feb 15th. This would be an unprecedented amount of float shorted which could create a huge short gamma squeeze in addition to an index gamma squeeze. By comparison, TSLA had a much bigger float in 2020 with 600bn market cap and only had 3% of shares short at S&P 500 inclusion. 

SMCI has been eligible for inclusion into the S&P 500 since Q2 last year and had the index committee added it sooner, this index gamma impact would be more muted.

SMCI is currently the largest Russell 2000 component at 1.7%. Russell and S&P are different index families so SMCI will be in both until June 28th as it would be too large for the Russell 2000 and moved into the Russell 1000. The Russell 2000/1000 is a smaller impact but will create negative selling pressure on SMCI when this occurs in late June. Approximately 1.7trn is indexed to the Russell 2000 but SMCI is over 14x the size in the Russell 2000 vs S&P 500. 

With the recent run-up in SMCI and short interest, this will cause index gamma fireworks leading to the March 18th S&P 500 inclusion and June 28th Russell 2000/1000 rebalance.

 

As always your thoughts and feedback are very much appreciated!