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'Greater fool' theory powers Tesla shares' ascent

Investors expect passive funds to buy stock at any price after addition to S&P 500

Tesla's valuation is nearing the rarefied territory of the tech giants.   © Reuters

TOKYO -- Few names in global markets are as hot as Tesla right now.

The electric-car company raced past Toyota Motor on July 1 to become the world's most valuable automaker. Its market capitalization hit $332.9 billion on Monday -- as large as Japan's seven biggest auto manufacturers combined.

Tesla's stock chart calls to mind dot-com companies during the 1999 boom and bitcoin's meteoric climb in 2017, but its gains have some basis in reality. The transition from internal-combustion engines to electrics is a real trend, which partly explains why investors have remained steadfast as the company's valuation approaches tech-giant levels.

But expectations of high growth cannot fully account for Tesla's exponential rise. It appears that some investors have bought into the stock with the belief that someone else would buy it from them at an even higher price.

Who this "someone else" is seems clear: passive investment vehicles such as index-linked exchange-traded funds.

When Tesla announces April-June earnings on Wednesday, it is widely expected to report a fourth straight quarter of net profits, meeting the last remaining requirement for inclusion in the S&P 500. Roughly $4.4 trillion is invested in funds linked to the benchmark index, and Tesla's inclusion would spur the purchase of an estimated 25 million shares in the automaker -- regardless of price.

Investors are bidding up the stock in anticipation of this wave of automatic buying.

The "greater fool" theory posits that one can purchase overvalued securities if there is someone else waiting in the wings willing to pay an even higher price.

When passive investing was first developed in the 1970s, it was meant to be a smart approach to asset management characterized by low costs and efficiency. Now it appears that passive indexes, with their outsize scale, have adopted the role of the bigger fool, introducing market distortions in their wake.

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