Money Stuff: Index Funds Can’t Say No to SpaceX

The basic idea of index investing is that you are not smarter than the market, so you should just buy whatever stocks the market tells you are good. It is a discipline of self-effacement, but it is hard. “The market is stupid,” you will occasionally think, and then what?

The most straightforward form of indexing is that you invest in all of the public companies in proportion to their size, but the best form of indexing would clearly be “you invest in all of the good public companies in proportion to how much they will go up.” Like if there were an Index of Good Companies, you’d rather buy that than the Index of All the Companies. [1] This is hard to achieve for fairly obvious reasons: If the person picking the Index of Good Companies knew which companies would go up, she’d be managing a hedge fund, not an index. 

Still, there are temptations. We talked last week about SpaceX’s initial public offering, planned for next month. Three things you might not like about SpaceX are:

1. Its governance. “When SpaceX is public,” I wrote last week, “Elon Musk still gets to run it however he wants, and he can do weird stuff, and you have to trust him, and if you don’t like it you can’t complain.” Basically SpaceX has eliminated all of the main checks on corporate managers — shareholder voting, fiduciary duties — so Musk can operate with a free hand. “The most management-favourable governance structure ever brought to the US public markets at this scale,” some big public pensions called it.
2. Its valuation. Last year, SpaceX lost $4.9 billion on $18.7 billion in revenue; now it is trying to go public at something like 100 times revenue. Seems high!
3. Its float. Right after the initial public offering, SpaceX won’t have very many shares available to buy. It will probably sell on the order of 5% of its stock in the IPO; the rest will be subject to lockups that restrict trading until at least August. [2] Even if you like the company, you might not want to get into a bidding war with Elon Musk fans over its scarce shares.

If you are an active investor making decisions about your own portfolio, these reasons might deter you from buying SpaceX stock. Or they might not. It’s a free country! Nobody’s going to force you to buy SpaceX stock.

If you are index fund manager, though, somebody — your index provider — might force you to buy SpaceX stock. You might react to that with equanimity: “Well, my job is to buy all the stocks, and SpaceX will be a stock, so here we go.” You might find it upsetting, though. “I don’t want to sign up for a company where Elon Musk can do whatever he wants,” you might think. Or: “I don’t want to buy a company at 100x revenue just because the final dumping place for pumped-up stocks is an index fund.”

And historically index providers were in the business of making these sorts of quality decisions, so that index funds were not forced to buy stocks they didn’t like. For instance:

1. From about 2017 until 2023, some big index providers tried to exclude new companies with dual-class stock that gave their founders voting control, on the theory that that’s bad governance and index funds shouldn’t have to buy companies with bad governance.
2. Some indexes — most notably the S&P 500 — have profitability requirements, on the theory that companies that lose money are bad and index funds shouldn’t have to buy companies with bad earnings. (This kept Tesla Inc. out of the S&P 500 for years.)
3. Most indexes have some sort of float minimum or float-weighting, so that public companies with only a few traded shares are not overrepresented in the index, on the theory that index funds shouldn’t have to buy stocks that are hard to buy. Also, many indexes have some sort of “seasoning period,” where a company can’t join the index for some time after it goes public, so that the price can normalize.

These rules create some tension between the idea that an index is a list of all the stocks and the idea that an index is a list of all the good stocks. Historically, it didn’t matter all that much: The point of the stock market is to tell you which stocks are good, so a company with a high stock valuation should be a very good company, so it should get a high weighting in both the Index of Good Companies and the Index of All the Companies. Maybe those indexes will differ at the margins — maybe a midsize unprofitable poorly governed company will sneak into the Index of All the Companies but be barred from the Index of Good Companies — but the biggest drivers of returns will be the same.

But SpaceX — and also maybe OpenAI and Anthropic in their coming IPOs — will probably break that link. SpaceX will probably (1) do all sorts of stuff that index funds hate and that index providers have specifically tried to exclude and also (2) be gigantic, because the market loves it. The index providers will have to decide: Are they in the business of giving passive investors exposure to all the stocks that the market thinks are good, or to all the stocks that the index committee thinks are good?

There’s only one plausible answer. Last month, S&P Dow Jones Indices launched a “Consultation on Treatment of MegaCap Companies,” the gist of which is that, if the stock market is enthusiastic enough about a stock, who is S&P Dow Jones to stand in the way? 

S&P DJI defines a “MegaCap” company as one with a total company level market capitalization equal to or greater than the 100th largest company in the S&P Total Market Index (TMI). ...

MegaCap IPOs have the potential to achieve immediate and material investor ownership, trading liquidity, and market relevance, yet adherence to the existing index eligibility rules could prevent such IPOs’ timely index inclusion and impact the overall index’s effectiveness as a benchmark.

Through this consultation, S&P DJI is seeking feedback regarding whether the proposed, narrowly-defined rule exceptions for MegaCap companies and adjustment to the IPO seasoning period would enhance the continued ability of the subject indices to reflect the investable market universe while maintaining the core principles of transparency, consistency, and replicability that underpin S&P DJI index construction.

So S&P is thinking about letting the MegaCaps join the index after six months, not the usual 12, and waiving the minimum-float and profitability requirements. The goal is to “reflect the investable market universe,” where I think “investable” is used in the neutral sense (“is it possible to click a button to buy the stock?”) rather than the normative one (“I would never invest in that; it’s uninvestable”). Other index providers, as we have discussed, have planned similar waivers and will allow SpaceX into indexes even faster.

I appreciate that S&P Dow Jones is doing this only for the biggest companies (SpaceX, OpenAI, Anthropic). There are cases in which the index providers will substitute their judgment about what’s investable for the market’s judgment. But at some high enough valuation, you gotta defer to the market. 

I can see how it might be annoying. The Financial Times reports:

Todd Sohn, chief ETF strategist at Strategas, said the small volume of available shares following the SpaceX listing means the index inclusion will feel “almost a little frantic, because you’re dealing with ETFs and passive products that are tracking trillions of dollars of assets and yet you only have 5 per cent of float available”.

The anticipated post-IPO pop in the share price could leave passive investors buying at a hefty valuation, according to Sohn. “If SpaceX is up 100 per cent the week after the IPO, and they have to buy it, they have to buy it. They have to take that price . . . They can’t discriminate,” he said.

Right, the index funds can’t discriminate; that’s the main thing about them. Or I wrote last week:

SpaceX’s shareholders signed up for this deal — letting Musk cook — and have been rewarded; the people who buy into the IPO presumably want the same deal. Not all of them! Some index funds will own the stock soon without necessarily being Musk fans. … But most of the people putting in orders in the IPO are doing so because they like what Musk has done with the place and want more of the same.

If you are an index fund manager, you might care quite a lot about good governance: Index fund managers own all the companies, so they often focus on “systemic stewardship,” trying to nudge all the companies in broadly applicable good directions. Often this means nudging companies toward better corporate governance. So it must be particularly annoying to see Elon Musk inventing never-before-seen forms of bad corporate governance, and the stock market being like “meh that’s fine, wave it in.” But that’s life as a passive investor; you take what the market gives you.

You could model all of this as a sort of collective action problem. The theory might be “every institutional investor wants to say no to SpaceX’s governance and valuation, but they know that if they say no then someone else will say yes, and they worry that the stock will go up and they’ll look like idiots.” Your model could be that the index consultation process is a way for investors to do collective bargaining with SpaceX: If every investor said to S&P Dow Jones “no, we don’t want this in the index,” S&P Dow Jones wouldn’t waive its rules for SpaceX, and SpaceX would have to revise its IPO plans to be more investor-friendly. The investors couldn’t be picked off one by one, if the index stood firm. [3] The index provider, in this model, is sort of the collective voice of the market, able to push back on bad ideas from companies wanting to go public.

But really the people buying the stock are the collective voice of the market, and if enough of them buy the stock, then the passive investors have to buy it too.

If you went to the chief executive officer of, say, an airline, and said “hey I will sell you jet fuel at a 20% discount to the market price of jet fuel,” and she said “what’s the catch,” and you said “the catch is that it’s fake jet fuel, it’s just wastewater, it won’t fly your jets or anything,” she would say no. That is not a tempting offer. Her job is not to check a little box saying “Buy Jet Fuel.” Her job is to actually get planes to fly places, jet fuel is a necessary input to that, and she needs to buy fuel that is good enough to do the job.

If you went to the CEO of a public company and said “hey I will sell you carbon credits at a 20% discount to the market price,” and she said “what’s the catch,” and you said “the catch is that they’re fake carbon credits, we don’t do anything, we’re not reducing carbon emissions or removing any carbon from the air or anything, we’re just taking your money and giving you back a certificate,” she … might … say … yes? Oh she might not, she might care about the environment or worry about getting caught or whatever. But she does not need the carbon credits to do anything; they are not an input into anything except the environmental disclosures that she publishes. She needs the certificate, not any particular underlying reality. Her job, to some extent, really is to check a little box saying “Removed Some Carbon.”

Carbon credits just seem like a much, much, much easier subject of fraud than almost anything else. We talk about this problem from time to time. You’re selling people something that they can’t measure and don’t even really want. This weekend Bloomberg’s Petra Sorge and Natasha White reported:

Projects in the Changqing oilfield claiming to avoid almost 120,000 tons of CO2e emissions were registered with Austrian and Polish authorities in 2023 and with Luxembourg in 2021, according to a verification report and European Union data. But when Bloomberg reporters visited some of the locations listed in the documents in November and BloombergNEF analysed drone footage and satellite images of the vicinity, the projects did not appear to exist. One site was still under development and there was no sign of the equipment needed to trap emissions. ...

In Germany, a scandal over these Chinese credits sold into Europe’s government-run upstream emissions reduction (UER) scheme first erupted more than two years ago. Forty-five carbon-offset projects selling credits to major energy companies have been found by German authorities to be “suspicious,” to have overstated their environmental impact or to be fake. The authorities have withdrawn UER credits generated by two-thirds of these projects, an agency spokesperson said. …

None of the companies that bought the credits — including BP Plc, Électricité de France SA, Exxon Mobil Corp., MB Energy, MOL Group, OMV AG, the German-controlled subsidiary of Rosneft PJSC, Shell Plc, TotalEnergies SE and Vitol SA — are required to pay a penalty if avoided carbon emissions were inaccurately claimed. That’s because the offsets were purchased in good faith, a spokesperson for Germany’s General Customs Directorate said. In other words, the companies were using the system as it was designed.

Right, see, the purchasers get to keep the benefits of the carbon credits, even if they were fake, because they were purchased “in good faith.” That’s not how jet fuel works: If you buy fake jet fuel, you can’t fly your planes, and your business suffers, good faith or not. If you buy fake carbon credits, the environment suffers, but why is that your problem?

“It’s tough to make predictions, especially about the future”; predicting the past is somewhat easier. Prediction markets are in a loose optimistic theoretical sense “truth machines” that harvest the wisdom of the crowd to provide information about likely future events — will there be a war, a recession, a Knicks championship, etc. — but in practice they tend to resolve based on some official announcement of the event, and there is often a lot of money to be made by betting on events that have happened but not yet been confirmed. Reality television episodes tend to air long after they are filmed, so, Variety reports:

The winner of CBS’ “Survivor 50” was announced live on air on May 20.

But traders on prediction market platforms Kalshi and Polymarket — and “Survivor” fans exposed to reports of the fluctuating odds — saw Aubry Bracco’s payday coming before the season even began. ...

On Feb. 28, just days after the premiere and before Bracco had accumulated much screen time, a user bet $45,500 she would win the season (which later earned them a profit of $4,500). By market’s close on the day of the finale, a staggering $32.7 million in wagers had lifted her odds to 97%. ...

Pretaped reality TV shows are facing an unforeseen problem: Prediction markets are spoiling their endings. It’s not just “Survivor”: Kalshi users correctly predicted Galaxy Girl, at 91% odds, would win this season’s “Masked Singer” three months before Ashlee Simpson removed her space-themed costume in the finale. The site similarly spoiled the winner of “Next Level Chef” in February, though the season didn’t conclude until May 21.

If you use inside knowledge obtained by working at Survivor to bet on the winner, surely that is illegal insider trading and Kalshi will turn you in? Like you definitely signed a contract saying “I will not tell anyone the winner or trade on it.”

The three main justifications for prediction markets are:

1. They are fun gambling. I could see why, if you like watching Survivor, you might also like gambling on Survivor. Betting against insiders who know the outcome would spoil that, however.
2. They allow institutional investors to hedge real-world risks, lolololol. I will definitely get emails like “actually if a company has a commercial relationship with a Survivor contestant it might want to hedge its” yes right sure.
3. They are “truth machines” that provide positive externalities: Even if you don’t bet on prediction markets, you might find it useful to know who is (likely) going to win the next election, whether there will be a war or recession, etc. Making the world better informed about the future is arguably the main benefit and goal of prediction markets, the reason they got into the business. But making the world better informed about the winner of a reality show is strictly welfare-reducing! That’s a spoiler! Nobody wants that!

We talked last year, and again last week, about Fernando Tatis Jr. and the asymmetric risk of buying stock in people. Basically:

1. Fernando Tatis Jr. is a baseball player who, when he was an up-and-coming minor leaguer, sold a 10% stake in his future Major League Baseball earnings to a company called Big League Advance Fund for $2 million.
2. If Tatis had ended up a bust and never made any money in the majors, he would have kept the $2 million and repaid BLA $0. 
3. Instead Tatis did very well and signed a $340 million deal with the Padres in 2021, requiring him to pay BLA a large multiple of his $2 million advance.
4. If you think of this as “BLA bought stock in Tatis” then, sure, right, that’s what happens with successful venture equity investments. (And failed ones pay out zero.)
5. But Tatis is not a corporation and BLA did not actually buy stock: It gave him money upfront in exchange for money later, which is arguably a “loan.”
6. If it’s a loan, it has a super-high (realized) interest rate: The loan repays like $34 million, which on a simple yield calculation is a huge interest rate that is probably illegal under usury laws. [4]
7. In fact, Tatis sued last year to get out of the deal.
8. Therefore, for BLA, the possible outcomes are (1) bust and no repayment or (2) success, huge payout, but lawsuits to claw it all back.

Last week, Tatis lost his lawsuit for procedural reasons. (Here is the ruling, which is mostly about whether he waived objections to arbitration, etc.) “Fernando Tatis Jr. just lost a massive court battle — and it could cost him millions,” is the New York Post headline. I’m not sure buying stock in people will ever really take off as a normal asset class — adverse selection! moral hazard! it creeps people out! — but establishing that these deals are enforceable will help.

I do take crypto people’s central point, which is that in the modern world your money is just a set of entries in computer databases of for-profit companies that you have no control over or visibility into, and that’s unsettling. Like, if Fidelity or Vanguard or Chase or Robinhood deleted your account tomorrow, you’d be broke, and the only way to get your money back would be to call them up and persuade them to give it back to you, and they probably wouldn’t even answer the phone.

I am not convinced that crypto is the solution to this problem, though I don’t know what is. Regulation? Calling up newspaper columnists to complain? At the New York Times, Tara Siegel Bernard writes about a woman whose Fidelity accounts were accidentally deleted. Whoops!

It seemed that Fidelity had eliminated all traces of her longstanding financial relationship with it, erasing the tens of thousands of dollars she held in three accounts, including the Roth individual retirement account that her father had set up for her when she was 16 — and where she had made regular contributions ever since. Her online statements and tax documents had also vanished, so she couldn’t immediately find any of her account numbers, she said.

Now in full panic mode, she called Fidelity on her way into her clinic; it told her that she didn’t have any accounts there.

“Are you sure you shouldn’t be calling Schwab?” Ms. Gruntmane recalled one representative saying, referring to Charles Schwab. “Are you sure it’s with us?”

Even if her account was closed or deleted, the reps told her, they could usually see that. They also refused to connect her with the fraud department, Ms. Gruntmane recalled, for the same reason — if there wasn’t any trace of her accounts, how could there be a fraud?

Eventually she got her money back. This story is nightmarish and also surprising, because mostly financial intermediaries do try pretty hard and with notable success not to lose track of people’s money, but you cannot expect 100% perfection.

Elsewhere, the Financial Times reports:

The European Central Bank is to urge banks to speed up work to protect their IT systems, having summoned lenders to a meeting on Tuesday to discuss cyber security risks exposed by the latest AI models.

The ECB plans to stress the seriousness of the threat to the financial system revealed by Anthropic’s Claude Mythos Preview and similar AI models, while urging US banks that have been using the latest technology to share information with European rivals that lack such access.

“There is a whole range of issues on cyber security that we have been engaging on with the banks for years which are all still valid, but given the progress in AI, they need to be dealt with faster,” Frank Elderson, vice-chair of the ECB supervisory board that oversees banks, told the FT. …

The ECB’s hastily arranged meeting underlines how regulators around the world are rushing to tackle the risks that Mythos and other advanced AI models could pose to the global banking system by exposing weaknesses in lenders’ IT systems.

Is every bank’s list-keeping technology more advanced than Anthropic’s list-erasing technology? I dunno, man.

Bloomberg has a new subscriber-only newsletter called On Books. It’s about books, and it’s written by Silvia Killingsworth and James Tarmy. You can subscribe here, and you can read the first issue here. That issue features a list of “Matt Levine’s Favorite Books About Finance,” derived from a recent discussion on the Money Stuff podcast, if that’s the sort of thing that might interest you. However, I must emphasize that — as I said on the podcast — this is not a comprehensive list of my favorite finance books, and I could easily have named a bunch more if we had had more time. In particular:

1. Somehow I omitted Michael Gatto’s The Credit Investor’s Handbook, which is both a helpful and enjoyable guide to credit investing and also an omission that Gatto immediately noticed; and
2. Have you written a book about finance? I was going to say yours next, but I got cut off.

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