ETFs March 18, 2015

    The first ETFs were designed to provide broad, low-cost market exposure by mimicking the performance of the most popular indexes. Most of those indexes were "market-cap weighted," which means that the bigger a company's market capitalization—its share price multiplied by the number of outstanding shares—the larger its weight in the index. As a result, market-cap strategies tend to overweight overvalued stocks, and underweight undervalued stocks.

    Fundamentally different

    Fundamental strategies, on the other hand, weight stocks based on fundamental factors like sales, cash flow, dividend distribution and buybacks. Fundamental strategies across the market vary based on the factors they evaluate—one fundamentally weighted ETF might weight companies by sales, while another might weight stocks primarily based on cash flow, revenue, buybacks or some proprietary combination of these or other factors.

    Because fundamentally and market-cap weighted ETFs both track indexes, they provide similar cost advantages. However, their performance can vary widely. A market-cap index and a fundamentally weighted index focused on the same asset group will typically own similar stocks—but in different proportions.

    Fundamentally weighted and market-cap indexes may hold the same companies, but at different weights.

    Russell Fundamental US Large Company Index
    Exxon Mobil Corp 4.6%
    Chevron Corp 2.5%
    AT&T Inc 2.1%
    Microsoft Corp 2.1%
    Procter & Gamble Co 1.5%
    ConocoPhillips 1.5%
    Intel Corp 1.4%
    Wal-Mart Stores Inc 1.4%
    Verizon Communications Inc 1.4%
    General Electric Co 1.3%
    Russell 1000® Index
    (Traditional Market-Cap Index)
    Apple Inc 3.0%
    Exxon Mobil Corp 2.0%
    Microsoft Corp 1.9%
    Johnson & Johnson 1.5%
    General Electric Co 1.3%
    Berkshire Hathaway Inc 1.3%
    Wells Fargo & Co 1.2%
    JP Morgan Chase & Co 1.1%
    Chevron Corp 1.1%
    Procter & Gamble Co 1.1%

    Source: Russell Investments. Top 10 holdings as of September 30, 2014. For illustrative purposes only. Holdings are subject to change without notice. Not a recommendation or guarantee that any company has been or will be profitable.

    Take Apple Inc. (NASDAQ: AAPL), for example. Because it is the largest stock by market cap in the United States, it has the largest weighting in market-cap-based large-cap indexes. However, it might not have a prime position in a large-cap fundamentally weighted index that looks at economic factors.

    Differences add up

    The different weights assigned to companies in traditional market-cap-based indexes versus fundamentally weighted indexes mean that the indexes will perform differently. A few heavily weighted stocks have the power to influence the overall results of the index—for better or for worse. And because each type of index will overweight different stocks, these differences could lead to markedly different returns over time.

    The Apple effect

    Apple’s stock price has had a disproportionate effect on market-cap indexes.

    The graph compares the monthly closes of a fundamentally weighted index versus a traditional market-cap index. The Russell Fundamental US Large Company index is the fundamentally-weighted index, depicted in light blue bars, and the Russell 1000, a traditional market-cap index, is depicted in dark blue bars. The bar graph covers the time period from January 2012 to June 2013. The light blue and dark blue bars show monthly closes for both funds tracking relatively close together up until January 2013, when the fundamentally weighted index’s light blue bar closes near six, while the market-cap weighted dark blue bar closes around negative one. This pattern of positive closes for the fundamentally weighted index and negative closes for the market-cap index continues through May 2013. Apple’s weight in the Russell 1000 on September 30, 2012 was approximately 4%. Apple’s weight in the Russell 1000 on June 30, 2013 was approximately 2%. Source: Morningstar Direct, from January 1, 2012 to June 30, 2013. Past performance is no guarantee of future results.

    Source: Morningstar Direct, from January 1, 2012, to June 30, 2013. Past performance is no guarantee of future results.

    Splitting the difference

    Given their unique construction, fundamentally weighted ETFs can complement traditional index ETFs in a portfolio. To help ensure that you are truly diversified, Schwab Intelligent Portfolios™ invests in both market-cap-based and fundamentally weighted ETFs with the goal of helping to reduce volatility and provide better risk-adjusted results.

    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).

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

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

    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.

    (0115-0071)


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