Index funds no longer safe? How the SpaceX IPO is rewriting the rules of passive investing

Original Author: Quoth the Raven

Original Translation by: Peggy

Let’s talk about what’s happening in the capital markets, and specifically what’s happening with index funds. But before we do, we need to understand what a “fall from grace” really looks like. To do that, we first have to talk about Pete Rose.

Pete Rose wasn’t just a baseball star; he was what every fan imagined a “baseball star” to be. He was covered in dirt, gave his all, tough, and tenacious. Later, he became a player-manager, the face of a franchise, and a representative figure for the sport.

But along the way, he made some mistakes. It turned out he committed what was, at the time, the cardinal sin: betting on his own sport. It’s ironic today, with sports betting available on everyone’s phone and advertised non-stop during every sporting event. But back then, people still cared about old-fashioned concepts like “integrity.” So the league decided to make an example of Pete Rose.

Fifteen years later, a broken Pete Rose, needing to pay the bills, had to lend his remaining fame to WrestleMania. Soon, he found himself in the ring, facing a 400-pound Samoan wrestler named Rikishi.

I must warn you here: watch this clip with caution. Because Rikishi has a signature move called the stinkface. It is exactly as “classy” as it sounds: Rikishi would trap his opponent sitting in the corner of the ring, turn around, back up, and smash his enormous rear end into the opponent’s face, while the crowd goes wild.

You can look it up yourself. It’s as bad as it sounds.

While Rikishi was rubbing his massive backside across Pete Rose’s face, if you look closely, you’ll see something uncommon: a certain look in Pete’s eyes. It’s a mixture of sadness and acceptance. It’s the look of a man who realizes how far he has fallen. His eyes are no longer angrily fighting his current situation; they are dazed, weary, and accepting of this new, pathetic reality.

John Bogle is no longer with us. I can only imagine the look on his face if he saw what is happening to index funds today. I can only imagine it would be the same sad look. The same dazed, weary acceptance: his great invention, once standing so tall, is now descending into a sewer of fraud.

If you’ve been reading my work for a long time, especially when I wrote more about stocks and ETFs, you can probably guess what I’m going to say. But if you’re a new reader, let me fill you in on the background. Here’s how things actually unfolded:

Low-cost investing was once a powerful narrative, positioning the average investor against greedy Wall Street;

This narrative drove capital inflows into passive index funds;

Capital inflows drove performance, allowing the market-cap weighting factor—essentially a combination of an anti-small-cap factor and a momentum factor—to outperform all other factors;

Outperformance led to more capital inflows, closing the loop;

Options trading volume surpassed spot stock volume, and derivatives linked to the largest indices began driving prices deeper than the index funds themselves;

Thus, valuation ceased to matter for the market.

All of this has brought us to today, and to the Rikishi moment we are now facing. That moment is the SpaceX IPO.

First, Nasdaq modified the Nasdaq-100 index rules to make it easier and faster for newly listed mega-cap companies like SpaceX to enter the index. These rule changes seem to weaken traditional index standards regarding free float, liquidity, investability, and replicability. Time will tell if this is good or bad for investors. But one thing is certain: it’s very favorable for Nasdaq’s efforts to secure SpaceX as its primary listing venue.

You could certainly say that allocating stocks based on their primary listing exchange is crazy. You would be right to say so. I’ve been to those pitch meetings. Why a company chooses to list on the NYSE versus Nasdaq has absolutely nothing to do with the relative investment value of the S&P 500 or the QQQ. We are talking about two completely disconnected worlds.

For example, people think they are buying tech stocks when they buy the Nasdaq-100, but it contains Costco, Walmart, and a bunch of other things. They might also think they can buy Oracle or Uber, but they can’t, because those companies chose to list on the NYSE for reasons completely unrelated to your portfolio. So you miss out on them.

This is insane.

But it’s always been this way. And now it’s worse. Because this time, it’s not just about the listing venue. All the index companies have modified their index methodologies, all in an effort to force-fit companies like SpaceX, Anthropic, and OpenAI into the indices. If valuation still matters, the price at which index fund investors will buy these companies will make you sick.

According to Hedgeye, the damage is as follows:

Rule changes surrounding the SpaceX IPO:

Index providers waived profitability requirements and shortened the post-listing observation window from 90 days to 5 days.

This will force over $30 trillion in passive 401(k) and retirement funds to buy SpaceX at its IPO valuation.

Bloomberg Intelligence estimates that S&P 500 funds must absorb 19% of SpaceX’s free float within 6 months.

Russell 1000 and Nasdaq-100 funds will absorb 24%.

The rules originally designed to protect passive investors:

Since 2002, the S&P 500 has required companies to have a 12-month trading history and four consecutive quarters of GAAP profitability. Both requirements are now waived.

Nasdaq shortened its inclusion window from 90 trading days to 15 trading days.

FTSE Russell shortened its window to 5 trading days.

All three benchmark indices are now designed to buy SpaceX at its IPO pricing level.

This is that moment. It’s the “jump the shark” moment for index funds. This is the moment when the great Pete Rose stares at Rikishi’s enormous backside with that look of despair.

Investors are no longer just outsourcing stock selection. They are also outsourcing asset allocation, IPO discipline, liquidity judgment, valuation discipline, listing venue selection, and prudence. They have outsourced all initiative in their own trading to index committees that blow with the wind.

Indices are no longer neutral. They are making active bets, and betting on the most frothy companies, at the peak of their valuations.

Active management has never had a better entry point. Direct indexing has never been more important. A massive shift is finally approaching.

Everything you’ve ever been told about “smart but boring” index funds is no longer true.

Get out while you still can. Choose your own methodology, choose your own factors, choose your own stocks, and retake control of your own portfolio.

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