ETFs July 2, 2018

    Fundamental indexing has been widely adopted since it was first introduced more than a decade ago. As of December 31, 2017, more than $170 billion was invested in strategies based on fundamentally weighted indexing.1

    Despite this widespread adoption, many investors aren't fully aware of fundamental indexing and its potential benefits. This brief article is designed to help answer three key questions for investors about this new form of indexing:

    1. What do fundamentally weighted indexes measure and how are they constructed?
    2. How has fundamental indexing historically impacted portfolio performance?
    3. Does the potential outperformance justify the cost of fundamental indexing?

    How indexes have traditionally been built

    Indexing has traditionally meant investing using market-cap weighted indexes such as the well-known S&P 500® Index. In these indexes, companies with the largest market capitalization hold the largest positions. Apple is currently the largest U.S. company based on this measure, with a market cap of more than $900 billion.

    Market cap = share price x number of shares outstanding

    Traditional indexing is low cost and provides diversification—benefits which explain why Schwab Intelligent Portfolios® has a large allocation to these types of funds. But weighting by market cap means that a company’s share price has a big influence on how much of the index it represents. And anybody who lived through the boom and bust of the late-1990s tech bubble, and the 2008-2009 financial crisis, knows that stock prices can become wildly overvalued and undervalued based solely on investor enthusiasm and pessimism. This means that the amount invested in each company based on a market cap index can be driven up or down by changes in investor sentiment at times rather than factors such as the company's economic footprint.

    The rise of fundamental indexing

    Over the past decade, a new form of indexing has flourished. Fundamentally weighted indexes break the link with stock price in determining a company's size and instead select and weight constituents by objective financial measures, such as:

    • Sales
    • Cash flow
    • Dividends

    In a fundamentally weighted index, a company that generates large amounts of revenue would typically have a larger weight than a firm with little revenue. Fundamental indexes benefit from anchoring company weights in the index to these non-price measures and periodically rebalancing back to them. This helps avoid the systematic overweighting of overvalued securities that can occur in market-cap weighted indexes and imposes a "buy low-sell high" discipline as markets fluctuate.

    Market-cap indexes and fundamentally weighted indexes typically invest in similar companies but at different weightings. This results in performance variations in different market environments over time. Including both types of indexing helps enhance diversification within the stock portion of a portfolio.

    For example, Table 1 shows the top 10 holdings for two U.S. large-cap stock indexes at the end of 2017, a market-cap index and a fundamental index. Apple is included in both indexes, but at a smaller weight in the fundamental index. An even better example is Facebook, which rose to the 4th largest company in the market-cap index in recent years as its stock price surged. By contrast, in the fundamentally weighted index, Facebook was ranked number 175, representing just 0.12% of the index.

    These discrepancies in weighting mean that the amount of money you invest in each company can deviate significantly between these two types of indexing and result in meaningful differences in performance.

    Table 1: U.S. large company stock indexes: Top 10 holdings, as of Dec. 31, 2017
    Market-cap index Weight (%) Fundamental index Weight (%)
    Apple 3.5 Exxon Mobil 3.8
    Microsoft 2.5 Apple 3.0
    Amazon 1.8 Chevron 2.5
    Facebook 1.6 Microsoft 1.8
    Berkshire Hathaway 1.5 Wal-Mart Stores 1.7
    JPMorgan Chase 1.5 AT&T 1.6
    Johnson & Johnson 1.5 Intel 1.5
    Exxon Mobil 1.4 Pfizer 1.4
    Alphabet (C class) 1.2 JPMorgan Chase 1.3
    Alphabet (A class) 1.2 Verizon Communications 1.2

    Source: Morningstar Direct, as of 12/31/2017. The market-cap weighted index is the Russell 1000® Index and the fundamentally weighted index is the Russell RAFITM U.S. Large Company Index. Indexes are unmanaged and cannot be invested in directly.

    Fundamental indexing has delivered outperformance historically

    More than a dozen research papers published over the past decade have found that fundamental indexing has generated outperformance over market cap indexing of approximately 1% a year in asset classes, such as U.S. large company stocks over the long term, and more in areas such as small company stocks. However, each form of indexing can lead in different market environments, which is why we believe a combination can help provide additional diversification within a portfolio. At the same time, fundamental indexing retains the advantages of traditional indexing such as diversification and low costs. (A brief list of some of these papers is included at the end of this article.)

    As illustrated in Table 2, the fundamentally weighted U.S. large company index outperformed its market-cap weighted counterpart in four out of the seven years since its inception. The fundamentally weighted U.S. small company index outperformed in five of the seven years. Fundamental indexing significantly outperformed in 2016 but underperformed in 2017 when a momentum-driven market environment with little volatility favored market cap indexing.

    Over the full 7-year period since inception, the large cap fundamentally weighted index slightly underperformed due to the recent tailwind for market cap indexing. However, the small cap fundamentally weighted index meaningfully outperformed its market cap counterpart, again illustrating the benefits of including both forms of indexing. Notably, the volatility of the fundamentally weighted indexes is comparable to, or slightly lower than, that of the market cap weighted indexes.

    Table 2: Index leadership varies over time (February 24, 2011 – December 31, 2017)
      Annual total returns (%) Annualized total return (%) Annualized volatility (%)
      2011* 2012 2013 2014 2015 2016 2017 Feb. 24, 2011 – Dec. 31, 2017
    Russell RAFI US Large Company Index -2.3 16.7 34.9 12.7 -2.6 16.7 17.3 13.0 17.2
    Russell 1000® Index -2.6 16.4 33.1 13.2 0.9 12.0 21.7 13.3 17.4
    Russell RAFI US Small Company Index -7.0 18.9 39.4 8.2 4.8 23.8 13.0 12.4 21.9
    Russell 2000® Index -6.2 16.4 38.8 4.9 4.4 21.3 14.6 11.5 23.3

    Source: Morningstar Direct.

    *Returns for 2011 are for the period from the inception of the Russell RAFI Index Series on Feb. 24, 2011 through Dec. 31, 2017. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

    Keeping investor costs low

    But what about costs? Aren't costs for fundamentally weighted ETFs higher than for market-cap weighted ETFs? For example, some U.S. large-cap ETFs have operating expense ratios (OERs) as low as 0.03% and U.S. small cap ETFs as low as 0.05%. By contrast, fundamentally weighted ETFs can have OERs of around 0.25%. Although this OER is modestly higher, it is less than the higher longer-term return per year shown in the research and in the combined large cap and small cap outperformance of 0.60% per year shown in Table 2.

    How Schwab Intelligent Portfolios Can Help

    Investors may benefit from market cap-weighted ETFs along with the diversification benefits from fundamentally weighted ETFs.

    David Koenig CFA®, FRM®, Vice President and Chief Investment Strategist for Schwab Intelligent Portfolios®

    1. Research Affiliates


    • Arnott, R., J. Hsu, and P. Moore, "Fundamental Indexation," Financial Analysts Journal, March/April 2005.
    • Arnott, R., J. West, "Fundamental Indexes™: Current and Future Applications, Institutional Investor's fifth annual Exchange-Traded Funds Review, Fall 2006.
    • Arnott, R., V. Kalesnik, P. Moghtader, C. Scholl, "Beyond Cap Weight: The empirical evidence for a diversified beta," Journal of Indexes, January/February 2010.
    • Amenc, N, F. Goltz, A. Lodh, "Choose Your Betas: Benchmarking Alternative Equity Index Strategies," The Journal of Portfolio Management, Fall 2012.
    • Dempsey, M., "The Controversy in Fundamental Indexation: Why Both Sides of the Argument Are (Mostly) Correct," Journal of Investment Management, Fourth Quarter 2012.
    • Goodwin, T., "The Russell Fundamental Index Series: An Investment Strategy," Russell Research, September 2012.
    • Chaves, D., R. Arnott, "Rebalancing and the Value Effect," The Journal of Portfolio Management, Summer 2012.
    • Towers Watson, "Understanding Smart Beta," July 2013.
    • Amenc, N. F. Goltz, L. Martellini, "Smart Beta 2.0," Edhec-Risk Institute, June 2013.
    • Goodwin, T., "Passive and fundamental index investing: A factor analysis," Russell Research, June 2013.
    • Arnott, R., J. Hsu, V. Kalesnik, P. Tindall, "The Surprising Alpha From Malkiel's Monkey and Upside-Down Strategies," The Journal of Portfolio Management, Summer 2013.
    • Bull, P., "Fundamentally Weighted Global Small Companies," The Journal of Portfolio Management, Summer 2013.
    • Tower, E., C. Yang, "Is Traditional Indexation Passe? Vanguard Versus the Enhanced Indexers: DFA, RAFI, and WisdomTree," The Journal of Index Investing, Summer 2013.

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

    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 Indexes. Charles Schwab & Co., Inc. is not affiliated with Russell Investments or Research Affiliates.

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


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