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A Peek Inside Fundamental Strategies

You know what an index fund is, and how it works. Basically. But the actual construction of most traditional index funds might surprise you. The indexes you know and love (the S&P 500® Index, the Russell 1000® Index, etc.)—and the funds that track them—typically use a stock’s market capitalization to determine the stock’s weight in the portfolio. Thus, the bigger a company’s market cap, the larger a company’s weight in an index. Market-cap strategies tend to overweight overvalued stocks and underweight undervalued stocks.

Fundamentally weighted strategies break away from the market-cap approach—and the bias toward overvalued stocks—and instead weight stocks based on economic factors such as sales, cash flow and return of capital to shareholders (stock buybacks and dividend payouts).

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A traditional market-cap index and a fundamentally weighted index that focus on the same asset group will typically own similar stocks. But the proportions are quite different, as you can see above. These are the five largest holdings in two indexes that focus on large-cap stocks: one a traditional index, and one that’s fundamentally weighted. The difference in weighting can lead to dramatically different returns over time.

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Size and popularity don’t get you anywhere with a fundamentally weighted index. A prime case in point is Apple, the largest stock by market cap in the United States. While that earns Apple the largest weighting in traditional indexes, it does not guarantee Apple a prime position in a large-cap fundamentally weighted index that looks at economic factors.

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The chart above shows Apple’s effect on index performance based on its weight in a traditional index versus a fundamentally weighted one. When Apple generated a 65.4% return in 2012, the traditional index slightly outperformed the fundamentally weighted index by 1.2%. However, when Apple’s stock performance struggled in 2013, dropping by 39.5%, the fundamentally weighted index fared better.

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Fundamentally weighted strategies have also been effective in emerging markets. Rather than arbitrarily overweighting large multinational companies, fundamentally weighted indexing weights companies based on economic factors. The difference in weighting methodology can lead to dramatic differences in company, country and sector allocations. 

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Given its unique hybrid construction, a fundamentally weighted strategy can complement a traditional market-cap index approach. There can also be a place for active management, especially for those active managers that have historically done a better job of protecting wealth in falling markets. Constructing a portfolio using these three building blocks is a mix of art and science. Above is a sample stock portfolio that mixes all three components.

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Important Disclosures

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

The S&P 500 Index is a market-capitalization-weighted index comprising 500 widely traded stocks chosen for market size, liquidity and industry group representation.

The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership.

The Russell Fundamental U.S. Large Company Index ranks companies in the Russell 3000 Index by fundamental measures of size and tracks the performance of those companies whose fundamental scores are in the top 87.5% of the Russell 3000 Index. The index uses a partial quarterly reconstitution methodology in which the index is split into four equal segments at the annual reconstitution and each segment is then rebalanced on a rolling quarterly basis. Performance includes reinvestment of dividends.

The Russell Emerging Markets Index measures the performance of the investable securities in emerging countries globally. The Russell Emerging Markets Index is constructed to provide a comprehensive and unbiased barometer for this market segment and is completely reconstituted annually to accurately reflect the changes in the market over time.

The Russell Fundamental Emerging Markets Index Series selects, ranks, and weights securities by fundamental measures of company size as opposed to market capitalization. The fundamental overall company scores are created using as the universe the members of the Russell Emerging Markets Index. Securities are grouped in order of decreasing company score for each index and each company receives a weight as a percentage of the sum of the weights of the individual securities within each index.

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

Russell Investments and Research Affiliates, LLC have entered into a strategic alliance with respect to the Russell Fundamental Index Series. Subject to Research Affiliates’ intellectual property rights in certain content, Russell Investments is the owner of all copyrights related to the Russell Fundamental Index Series. Russell Investments and Research Affiliates jointly own all trademark and service mark rights in and to the Russell Fundamental Index Series. Charles Schwab & Co., Inc. is not affiliated with Russell Investments or Research Affiliates. 

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

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