Tom Bailey: GameStop’s potential S&P 500 entry blurs active and passive lines

There is speculation that GameStop will be added to the S&P 500 - what does this tell us about the active versus passive debate?

Back in January, GameStop (NYSE:GME) shares saw astronomical gains. The company’s primary business was selling video games in physical stores in shopping malls across America. That has not been a particularly exciting business model for several years. It should have been even less popular during a global pandemic, where bricks and mortar stores were either being forced to closed or avoided by those worried about the virus.

But of course, GameStop’s share price did not skyrocket because anyone thought its current business model was anything to shout about. The story was much weirder. Initially, members of the Reddit Wall Street Bets community identified it as a potential buy due to its pivot towards digital sales being overseen by activist investor Ryan Cohen.

But from here, GameStop’s share price started to creep up. As its price rise gained more attention, it took on a life of its own, with the stock seeing a renewed surge of buying. Motivations were mixed. For some, it was simply fun. For others, it was a chance to get in on some risky speculation. For others, the high prevalence of hedge funds shorting the stock turned it into a crusade against Wall Street. Whatever the reasons, from early December 2020 to the end of January 2021, the stock was up by almost 2,000%.

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Every sensible observer of markets and finance at the time was predicting the mania would not last. Why would it? Even if GameStop’s pivot to digital looked promising, nothing could justify its share price rise. And of course, the company’s share price did eventually collapse. From its peak on 27 January 2021, its price fell by almost 90% in mid-February. The meme stock was over, the joke had run its course – or so it seemed.

Oddly, GameStop’s share price has stayed persistently high. Since the February price collapse, it has gradually recovered. Measured from its February depths, the share price is up by over 350%. It now has a market cap of over $14 billion. This raises all sorts of questions about how well capital markets are functioning right now.

Important for us, however, is that all this has created speculation that GameStop has the potential to be added to the gold standard of stock market indices: the S&P 500. With a market cap of $14 billion, GameStop is bigger than many of the smaller companies found in that index. If the company is added, that would result in a surge of inflows. According to S&P Global Indices’ Annual Survey of Assets, an estimated $5.4 trillion dollars passively tracks the S&P 500 Index.

Of course, GameStop’s inclusion is far from a given. The S&P 500 has an inclusion committee that makes any final decisions about entry into the index. In addition, the index has a profitability requirement that GameStop will have to meet first. However, most importantly, even if all the objective requirements for index inclusion were met, it would still hinge upon the decision of S&P 500’s inclusion committee.

Given the weird history of the stock’s rise, its reasonable to assume the index’s gatekeepers will be reluctant to add GameStop anytime soon. That’s perhaps good news for investors. No one wants to be a forced buyer of a share that is wildly overvalued because a bunch of people on the internet decided it would be fun to buy it all at once and watch its price go up.

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But hold on, is this not active management? If the S&P 500 committee decide that GameStop is overvalued or too risky to include, they are behaving like an active manager does. This is the sort of human-based subjective decision making that advocates of passive investing and the efficient market hypothesis claim usually leads to worse outcomes.

There is some truth to this. The active decision making of the S&P 500 committee may end up saving investors from having GameStop in their S&P 500 tracking funds. But it works both ways. The S&P 500 last year also famously delayed the inclusion of Tesla (NASDAQ:TSLA) in the index even after it met the objective eligibility requirements (market cap, profitability). That was a drag on returns to passive investors tracking the S&P 500. It contributed to the S&P 500 underperforming the MSCI USA Index in 2020. The latter does not have an index committee making inclusion divisions about individual stocks and so already included Tesla.

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So sometimes the S&P 500 committee gets it right, sometimes wrong. Humans can get things both wrong and right. Excluding GameStop may be the right decision and not including Tesla sooner may have been the wrong decision. But its impossible to know these things ahead of time with any certainty. But is that really some point in favour of active investing and against passive?

The whole point of being a passive investor is to track a basket of shares regardless of the market prices instead of trying to work out which ones are over or undervalued. Buying the index can sometimes mean buying overvalued stocks. It can also mean at times missing out on undervalued stocks or being forced to buy overvalued stocks because of the quirks of the index is constructed.

But the point is you will still probably buy overvalued shares or miss undervalued shares with less frequency than active managers.