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Indexing Takes a New Turn

Fundamentally weighted indexes offer a new approach to investing that melds classic indexing strategies with some benefits of active management for what is arguably the best of both worlds. 

The big idea: “Fundamental strategies are a hybrid approach that use a systematic rules-based philosophy to construct portfolios,” says Tony Davidow, asset allocation strategist at the Schwab Center for Financial Research.

Indexing 1.0

Traditional index funds have their benefits—they hew closely to their benchmarks and have lower operating costs than their actively managed peers. But they have an odd bias: The more a stock’s price rises, the larger the weight that stock will have in the index. 

That’s because traditional index funds are market-capitalization weighted. Market cap, or market value, is the size of a company measured by multiplying its stock share price by the number of outstanding shares. That means the index is slanted toward holding a larger proportion of stocks that may be overvalued. 


Indexing Takes a New Turn

Indexing 2.0: An alternative to standard indexing

Enter fundamentally weighted indexes, which start with a similar universe of stocks as standard indexes, but ditch the market-cap weighting approach and instead focus on a variety of factors such as sales, cash flow and dividends plus buybacks. That is, the portfolio is weighted based on these fundamental factors, not market capitalization.

Portfolios that take a fundamental approach tend to have a more pronounced value tilt than a market-cap weighted portfolio. Moreover, while many traditional market-cap indexes add or remove stocks once a year, they don't rebalance. In contrast, fundamentally weighted indexes reconstitute annually and rebalance more frequently. This has contributed to the argument that fundamentally weighted indexes aren’t passive at all, but are actively managed. However, the “active management” in this case doesn’t derive from research and judgment, but from predetermined fundamental factors and metrics.

Part of the appeal of fundamental strategies has been their strong absolute and relative results.

“There are numerous studies showing how difficult it has been for active managers to consistently outperform their passive benchmark over time, especially when factoring in the impact of fees,” Tony observes. “Part of the appeal of fundamental strategies has been their strong absolute and relative results. Now that these strategies are available in exchange-traded funds (ETFs) and mutual funds, the average investor can access them in a cost-effective structure.” 

There are now fundamentally weighted ETFs that charge an annual expense ratio below 0.50%. That’s not as cheap as the 0.10% or less you can pay for a traditional index ETF, but it’s lower than many actively managed mutual funds. 

Put your index investing strategy to work

So how would you put this to work? Consider domestic large-cap stocks. Most of the information about them is readily available, so they’re a relatively efficient market. That doesn't leave much opportunity for an investor to outperform. Tilting your allocation toward fundamentally weighted funds may offer a better potential to generate alpha, because of their metric-driven index structure and because of their lower cost compared to actively managed funds.

Conversely, when it comes to less efficient markets—such as international and emerging markets—you may want to put a greater percentage of your assets in active funds, to harness the skill of certain managers.

Investing for the long haul

While fundamental strategies’ emphasis on value stocks may offer a positive experience over the long term, there will be periods when fundamentally weighted indexes underperform market-cap indexes. But for patient buy-and-hold investors with the resolve to tune out the noise, fundamental strategies can be a smart way to diversify a traditional index-based portfolio.

“We believe that fundamentally weighted indexes represent an evolutionary step forward,” says Tony. “There may be market environments where they lag their market-cap equivalents, but our research has shown that they have historically performed quite well relative to both traditional indexes and active management.”

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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.

Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.


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