Understanding Weighted Index Funds
Offering investors cost-effective, tax-efficient market exposure, index mutual funds have become ubiquitous since first introduced more than five decades ago. The vast majority of index funds mimic popular market-cap indexes such as the S&P 500® Index, Russell 1000® Index, and MSCI EAFE® Index. As time passed and mutual funds evolved, however, index providers sought more-innovative strategies. One that's gained particular traction is the Fundamental Index® strategy pioneered by Robert Arnott and his colleagues at Research Affiliates LLC, which selects and weights stocks by financial metrics that measure a company's economic value.
Fundamental strategies can serve as an effective complement to market-cap strategies and active management. When combined, these strategies may offer the potential to create more-attractive risk-adjusted portfolios. In fact, Schwab believes that both active and passive approaches should be used together to build diversified portfolios. Let's look at the attributes of each of these strategies and how they might be used in the context of an overall portfolio.
Most major indexes are market-cap weighted—that is, weights are calculated by multiplying the price of each security by its number of shares outstanding. In the case of stocks, this means that the largest company by market capitalization has the largest weight in the index. The primary appeal of strategies benchmarked to market-cap indexes is their ability to provide cost-effective exposure to a broad market or market segment.
Active managers of mutual funds generally seek to outperform their fund's benchmark. For example, a large-cap manager may be benchmarked to the S&P 500 Index, which tracks large-cap U.S. companies. Unlike index based strategies, active managers have greater flexibility and adaptability in responding to changing market conditions, so investors may benefit from increased returns and/or the potential for a reduced risk of loss. However, few managers have been consistently successful in outperforming their benchmarks over time, particularly after accounting for fees.
Like market-cap strategies, fundamental strategies can provide broad-based market exposure, but securities are selected and weighted based on what are known as "fundamental" financial metrics that assess some aspects of a company's business or payout to shareholders—such as earnings, sales or dividends. The rationale in making this distinction is that such factors are believed to represent a company's "true" economic value more accurately than market-cap weighting. Fundamentally weighted indexes are sometimes referred to as "smart beta" because they seek to provide broad market exposure (beta) on measures of a company's financial value.
Digging Deeper into Fundamentally Weighted Indexes
The range of fundamental factors on which to base an index is wide; examples include a company's price-to-earnings ratio, dividends, book value (assets minus liabilities), cash flow, sales and dividend policy. Different fundamentally weighted products may use different metrics, and as fundamentally weighted indexing continues to grow in popularity, new indexes will undoubtedly seek to set themselves apart by employing different metrics or combinations of metrics.
In constructing both market-cap and fundamentally weighted indexes, the starting place is the same: Index providers such as Standard & Poor's, Russell Investments and MSCI create a representative basket of stocks when they develop an index. Russell, for example, screens thousands of U.S.–based stocks for attributes such as liquidity, share size and number of shares outstanding; the resulting 3,000 stocks make up the Russell 3000® Index, the "parent" index for all of the company's U.S. stock indexes. This is the point at which the distinctions between weighting strategies begin.
As compared with market-cap weighting, fundamentally weighted indexes screen securities in a fashion similar to that of many actively managed funds, but by following a rules-based discipline for weighting securities, they are designed to remove emotion. Different index providers will use different techniques: some will weight all the factors equally; others might assign more or less weight to certain factors. Although, by their nature, fundamentally weighted indexes typically have a value tilt, they are not true value indexes in that they also may hold growth and core stocks.
Investors should be aware of the biases inherent in funds that stem from how indexes are constructed. With market-cap indexes, the stocks that hold the greatest weight are those of companies that market participants value most. This implies that the largest companies are the "best" companies. Some argue that market-cap indexes overweight overvalued stocks and underweight undervalued ones.
It's not difficult to see the potential shortcomings of market-cap weighting when considered in the context of both market volatility and investor emotion. Apple Inc. stock provides a good example (oft cited as the "Apple effect"). For most of 2012, investors bid up the price of this Wall Street darling, before it fell back to its pre-2012 share price in mid-2013. When Apple's stock price was rising, indexes that had large exposures to it benefitted. Conversely, when its share price dropped, those same indexes suffered. To illustrate how indexes can be affected, as of June 30, 2013, in the Russell 1000 Index, Apple had the second-largest weighting; in the Russell Fundamental U.S Large Company Index, it was the 70th.
Reconstituting and Rebalancing
Periodically, the stocks in an index are adjusted, generally for one of two reasons: when stocks are added to or removed from an index (known as "reconstitution"), or when a stock's weight is adjusted in an index ("rebalancing"). Fundamentally weighted index providers both reconstitute and rebalance, changing the stocks and their weights over time. Market-cap indexes only reconstitute. As a result, market-cap indexes let their winners "ride," so may be prone to "boom" and "bust" periods. Mutual funds based on fundamentally weighted indexes, on the other hand, may have slightly higher turnover costs due to more-frequent buying and selling as they rebalance.
Allocating Among the Strategies
Because market-cap and fundamental strategies and active management tend to perform differently across market cycles, they can be effective complements in a portfolio. Market-cap strategies tend to flourish when the largest companies are outperforming, whereas fundamental strategies tend to outperform in value-driven environments.
The Schwab Center for Financial Research has identified four key levers useful in making allocation decisions among active, market-cap and fundamental strategies: tracking error (the difference between a fund's return and that of its benchmark), loss aversion, alpha (a measure of excess return), and expenses. Applying those levers can help investors identify how they might make their allocation decisions. Market-cap strategies generally provide the lowest-cost exposure to markets and experience little or no tracking error, but they do not offer the potential for either downside protection or alpha. Fundamental strategies can also provide cost-effective exposure to markets, and they have historically delivered alpha, but they tend to have higher tracking error relative to market-cap strategies and no downside protection. Active managers seek to deliver alpha as well as downside protection, but they may not accomplish their goals, and they are also likely to exhibit tracking error and cost more. The chart below summarizes these impacts.
Personalize Your Portfolio
Portfolio construction, however, is both art and science, so an individual's needs and risk tolerance must be taken into consideration. While many investors may be comfortable making those determinations themselves—using the research and tools available through Schwab—others may not. For them, as always, Schwab is here to help.
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The S&P 500® Index includes 500 leading companies and captures approximately 80% coverage of available market capitalization. The MSCI EAFE Index comprises the MSCI country indices that represent developed markets outside of North America: Europe, Australasia and the Far East. The Russell 1000® index represents the highest-ranking 1,000 stocks in the Russell 3000 Index, which represents about 90% of the total market capitalization of that index.