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Fundamental Strategies

Fundamentally Weighted Indexes: An Alternative to the S&P 500?

Fundamental strategies represent an evolved way of looking at the market. Find out how they differ from market-cap strategies.

Many funds track indexes—baskets of stocks that represent a particular market or a portion of it. It's not possible to invest directly in an index. But indexes are useful for a lot of other reasons. Most exchanged traded funds (ETFs) and index-based mutual funds attempt to mimic index performance. Indexes also serve as benchmarks, or gauges of performance, for actively managed mutual funds and other investments.

However, not all indexes are built the same. Traditionally, equity indexes have been based on market capitalization. For these "market-cap" indexes, stock weights are calculated by multiplying the price of each individual stock by its number of shares outstanding. In other words, the largest companies have the largest weight in the index. Well-known indexes like the S&P 500® Index, Russell 1000® Index and MSCI EAFE® Index use this methodology.

As an investor, it's important to be aware of the biases in how indexes are constructed. With market-cap indexes, the stocks that hold the most weight are those of the companies market participants value most. This implies that the biggest companies are the “best” companies. Some would even say that market-cap indexes overweight the overvalued stocks and underweight the undervalued stocks.

In recent years, we’ve seen innovation in the way indexes are built. Academics and researchers have essentially been trying to answer the question: Are there other ways to create an index?

Among the answers proposed, one idea that has gained traction is fundamentally weighted indexes.

What are fundamentally weighted indexes?

Fundamentally weighted indexes select and weight stocks based on fundamental factors—financial metrics that assess some aspect of a company’s business or payout to shareholders—such as earnings, sales or dividends. The rationale here is that these fundamental factors may represent a company's "true" economic value more accurately than the size of the company. Fundamentally weighted indexes are sometimes referred to as smart beta because they seek to provide broad market exposure (beta) based on measures of a company's financial health.

What fundamental factors does Schwab use?

There's a wide range of fundamental factors out there, including everything from a company's price-to-earnings ratio to dividends, book value (assets minus liabilities), cash flow, sales, and dividend policy among others. However, based on research conducted by our partners at Research Affiliates® and Russell Investments, Schwab Fundamental Index* ETFs use the following three fundamental factors:

  • Adjusted sales are the average five-year sales for a company. These sales are called "adjusted" because they exclude the effects of any leverage, or debt, used by the company. Looking at sales gives us insight into the profitability of a business.
  • Retained operating cash flow is the five-year average of cash generated from company operations. This is the cash left over after paying for expenses and any dividends that can be reinvested in the business. Looking at cash flow gives us an idea of how well the company is being managed.
  • Dividends are the average dividends paid over the past five years and buybacks are the company's repurchase of its own stock in the marketplace during that time. Combined, these two measures are a good indicator of how a company uses its cash.

Same initial pool of stocks

Now, let's turn to how these fundamental factors are used. When creating an index, the first step is to determine which group of stocks to use. Index providers, such as Russell Investments and S&P Dow Jones, create a representative basket of stocks.

Russell, for example, screens thousands of US-based stocks for attributes such as liquidity, share size and shares outstanding. The resulting 3,000 stocks make up the Russell 3000® Index, the parent index for all of the company’s US stock indexes. This parent index is then broken up into sub-indexes based on capitalization size (stocks ranked 1–1,000 are large and mid caps; 1,001–3,000 are small caps). At this point, the indexes become more specialized.

And this is where we start to see the differences between market-cap and fundamentally weighted indexes. The stocks included in fundamentally weighted indexes are selected and weighted based on economic factors, not market capitalization.

How are stocks weighted? 

Fundamentally weighted indexes follow a rules-based discipline for weighting securities. Some fundamentally weighted index providers weight all the factors equally, using the average of each fundamental factor to compile the list of stocks in the index. Other index providers might assign more or less weight to certain factors.

Regardless of these individual decisions, it’s important to remember that the index provider follows a specific set of rules when constructing the index. This is how fundamental strategies differ from actively managed strategies, where the investment manager might follow a similar screening process but also use his or her judgment to tinker with the results.

It’s also important to note that, because fundamentally weighted indexes select and weight companies by economic factors, these indexes typically have a value tilt. However, they are not value indexes, as they also hold growth and core stocks.

How do fundamentally weighted and market-cap indexes differ?

Reconstituting and rebalancing the index

Periodically, the stocks in an index are reviewed. There are two main ways that this happens:

  • Reconstitution is when stocks are added or deleted from an index.
  • Rebalancing is when the stocks’ weights are adjusted in an index.

Fundamentally weighted index providers both reconstitute and rebalance—changing the stocks and their weights over time. Market-cap indexes only reconstitute—or change their stocks. As a result, market-cap indexes let their winners ‘ride’ and may be prone to ‘boom’ and ‘bust’ periods. Mutual funds or exchange-traded funds (ETFs) based on fundamentally weighted indexes may have slightly higher turnover costs due to the addition of rebalancing which requires buying and selling underlying securities.

How do they stack up?

Here's a side-by-side comparison of fundamentally weighted and market-cap indexes:

Comparing Index Caracteristics

What's the impact of the fundamental factors?

Now that we've discussed how fundamentally weighted indexes work, let's see how this methodology impacts the stocks in the index.

The table below shows the top 10 holdings in the Russell 1000® index and the Russell Fundamental U.S. Large Cap index as of June 30, 2013. While many stocks appear in both, their weights can be quite different.

Top 10 Holdings Motion Graphic

Take Apple, for example. The stock has the second-largest weight in the Russell 1000, due to its large market cap, but the 70th largest weight in the Russell Fundamental US Large Company Index, as of June 30, 2013.

Apple was the darling of Wall Street for several years. When Apple's stock price was rising, indexes that had a large exposure to the stock benefited. Conversely, when Apple's stock price dropped, any index with significant exposure felt the pain of the decline. Some refer to this as the “Apple Effect”—where a single stock can have a dramatic impact on a market-cap index. This effect occurs because market-cap indexes are directly tied to price movements of the underlying stocks.

Bottom line

Fundamentally weighted indexes break the link with price. Selecting and weighting securities based on economic factors leads to a different index construction and performance results.

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Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Past performance is no guarantee of future results.