Schwab "Index" Clients Exposed To $200M Tesla Gamble: What Could Go Wrong?

Beating the S&P 500 is easy when you simply refuse to follow the directions. But breaking with the benchmark can cut to the downside as well when the market winds reverse.

There’s usually less incentive to innovate a large-cap index fund than a McDonald’s burger. In both cases, the target audience actively craves a generic and infinitely commodified experience.

All they want is efficient exposure to the broad market: nothing fancy, nothing expensive, nothing surprising.

That’s what makes Schwab’s efforts to rock the Standard & Poor’s boat so controversial. On the one hand, the in-house U.S. Large-Cap ETF is beating the vanilla benchmark by 0.7% YTD, which makes Schwab account holders happy.

But that outperformance is almost entirely attributable to the fact that Schwab defied S&P years ago and added Tesla to what’s nominally an “S&P 500” portfolio.

The danger, of course, is even a 1% allocation to Elon Musk’s brainchild requires maximum conviction, which is why S&P has yet to add the stock to its blue-chip index.

Not in the index, just the “index fund”

Sure, Tesla is as profitable on paper as any other $375 billion company. Musk exerts less concentrated control over the stock than Mark Zuckerberg over at Facebook.

It’s just that S&P never trusted the numbers enough, and now that Tesla is bigger than Walmart, adding it to the index would make big waves in a fragile market.

Their loss has been Schwab’s gain. When and if they ever decide Tesla can join the index, Schwab will look even better. 

But in the meantime, Schwab lives and dies on its conviction. S&P 500 constituents are usually too big to fail, but with Tesla, a lot can still go wrong before Musk gets it right.

With $20 billion on the books, Schwab’s fund has about $200 billion riding on Musk getting it right. Failure could cost the fund all of its recent alpha, giving the vanilla index a change to fill the gap and then even outperform.

The percentages aren’t huge in any event, but in a world where investors park in commoditized portfolios based on minuscule fee discounts, every basis point can steer a lot of assets in or out. 

For now, Tesla is Schwab’s edge. They’re probably not going to let it go while it’s working. If the stock hits a hard wall, they’ll need to sell to make redemptions and rebalance.

Deliberate drift

The Schwab fund isn't marketed as an S&P 500 fund but for all practical purposes it fills that role in the in-house investment menu. This is their version. It's what account holders get when they want beta.

Even if people wanted to differentiate away from the S&P 500 model, there just isn’t a lot of meaningful change you can make. 

All funds that track the 500 biggest U.S. stocks will tend to have the same holdings in the same proportions, give or take a share on any given day. Variations in performance will require a microscope and should resolve over time.

Tesla creates a real divergence because we rarely see any stock reach this size without creating real consensus around the basic issue of whether it’s even going to be around in five years. You’re either on the electric bus or you aren’t.

S&P isn’t. Their public explanations remain nebulous enough that it’s pretty clear that they’re resisting the temptation to comment publicly on what they think the stock is worth. 

Fair value isn’t part of the index conversation. Indexers are usually content to pick the stocks that reflect a given slice of the market and then weight the portfolio accordingly. 

Tesla fits Schwab’s view but not the S&P 500. There will be a reckoning one way or another. As Tesla fans say, this has already proved that the S&P 500 is increasingly irrelevant.

We’ll just have to see. And tiny variations add up big as the random walk continues. Schwab fund has beaten the S&P 500 by 26 percentage points over the last five years. 

That’s huge. If the bets had gone the other way, investors on the Schwab platform who thought they were getting an S&P 500 experience would have underperformed by a similar degree.

They'd be furious . . . assuming of course that they stuck around this long.


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