Tesla (TSLA 0.29%) is one of the most controversial stocks in the market right now. Bulls believe that CEO Elon Musk is a visionary who will transform not just the transportation industry but also make massive changes across many different industries. Skeptics point to Tesla's market capitalization (which now exceeds the total of the market caps of the traditional Big 3 automaker stocks) as the epitome of irrational exuberance for a company that's only now starting to be consistently profitable.

The debate among shareholders, short-sellers, and vehicle enthusiasts rages on, with no signs of slowing down anytime soon.

Yet as Tesla's total value climbs well above the $100 billion mark, one thing is almost certain: It's only a matter of time before the stock gets a brand-new set of investors. In fact, the odds are good that you'll be one of them, whether you like it or not -- if you own shares of an S&P 500 index fund.

Next exit: S&P 500?

The S&P 500 index includes 500 of the biggest companies in the U.S. economy. The manager that oversees inclusion in the S&P 500, S&P Dow Jones Indices, frequently makes changes to the index constituents based on market movements, mergers and acquisitions, and other events. It's therefore typical that by the time a company reaches Tesla's size, it's already been in the S&P 500 -- often for quite a while.

Blue Tesla Model 3 sedan on a road in front of a picturesque landscape.

The Tesla Model 3. Image source: Tesla.

But S&P Dow Jones Indices does follow some rules in determining whether a company can become part of the S&P 500. A stock has to trade above $1 per share, and the company's overall market cap has to qualify under the manager's definition of large-cap status. S&P 500 stocks also have to have adequate liquidity to allow for substantial institutional trading, which S&P Dow Jones Indices defines as having at least half of its outstanding shares available to trade on public markets. That final restriction can limit newly public companies whose IPOs include only a small fraction of the total share count.

None of those rules snares Tesla. But the problem for the company is that although it's been profitable for the past couple of quarters, it hasn't made money over an entire trailing 12-month period. Until it does, Tesla won't be able to have its stock join the S&P 500.

Buying high

What many investors have just realized, though, is that Tesla could be just two quarters away from meeting that last hurdle for getting into the S&P 500. And if that happens, some of the biggest index funds in the market will suddenly find themselves having to buy shares no matter the price.

The reason: Individual and institutional investors have trillions of dollars invested in funds that track the S&P 500. The easiest way to do so is simply to buy all 500 stocks that make up the index. When one stock replaces another, then most index funds just sell the exiting stock and buy the new index constituent. Because the index will only start calculating its return once Tesla's stock becomes part of the S&P 500, the index fund manager won't really care what the stock's price movements looked like immediately before it became part of the index. The only objective for S&P 500 index funds is to match the underlying index's performance.

In other words, while most fund managers would feel dumb paying $700 or $800 per share for a stock that traded for below $200 less than a year ago, index funds have no choice. They're happy to pay whatever it takes to get shares -- no matter whether fund shareholders believe Tesla's a good buy or not.

Don't get too upset

Even if you'd rather not own Tesla at these levels, there are two reasons not to get too angry:

  • Tesla won't represent that much of an S&P 500 fund's assets in any event. Even at a $140 billion market cap, Tesla's weighting in the index is likely to be less than 0.5%.
  • Often, even controversial stocks have ended up doing well in the long run after getting added to the S&P 500. Companies like Alphabet and Facebook faced similar criticism when they entered into the index, but they've soared in the interim.

The idiosyncrasies of index funds make it important to understand what impact they can have on a high-flying stock. For Tesla, getting into the S&P 500 could well be just the latest excuse for another big leg up for the electric car pioneer's shares.