ETFs February 7, 2020

    The benefits of fundamental indexing

    Index investing has seen tremendous growth in recent years as investors have embraced its low costs and easy access to a broad range of asset classes and market segments. Schwab Intelligent Portfolios® takes advantage of two forms of indexing when constructing client portfolios: traditional market cap indexing and a newer type of indexing called fundamental indexing. Each of these has different characteristics, so including both within a portfolio can enhance diversification while retaining indexing's benefits of low costs, transparency and tax efficiency.

    How indexes have traditionally been built

    Since indexing was first introduced in the 1970s, it has traditionally meant investing in funds that track market-cap weighted indexes such as the S&P 500® Index. In market cap indexes, companies with the largest market capitalization (share price times the number of shares outstanding) make up the largest proportions of the index.

    While traditional index investing has many benefits, it's important to understand how stock price movement can drive a market cap index higher and lower. As a company’s stock price goes up relative to other companies in the index, it becomes a larger proportion of a market cap index, whether or not its earnings are also increasing. And anybody who lived through the boom and bust of the late-1990s tech bubble or the 2008-2009 financial crisis, knows that stock prices can be pushed both higher or lower by investor exuberance or pessimism alone.

    The rise of fundamental indexing

    Over the past decade, a new form of indexing has flourished. Rather than relying on stock price, fundamental indexing determines a company's size in the index using objective financial measures such as sales, cash flow and dividends. A simple way to think about it is that fundamental indexing is designed to reflect a company's economic size while market cap indexing reflects its market size. For example, a company that generates large amounts of revenue would typically have a larger size in a fundamental index than a firm with little revenue.

    In traditional investment style terms, market cap indexes inherently emphasize "growth" companies while fundamental indexes tend to emphasize "value" companies. Value stocks are generally "cheaper" as measured by price-to-earnings (P/E) and other valuation metrics, and typically have slower growth and higher dividend yields. Growth stocks tend to have faster earnings growth and higher valuations.

    These differences in emphasis for each type of indexing result in differences in performance in different market environments, so including both types of indexing can help enhance portfolio diversification. Market cap indexing tends to outperform fundamental indexing in growth-oriented or momentum-driven market environments, while fundamental indexing tends to outperform when momentum reverses and in more value-oriented market environments.

    Fundamental indexing can help enhance diversification

    The potential diversification provided by combining fundamental indexing and market cap indexing is shown in Figure 1. Over the full period since the launch of Schwab Intelligent Portfolios in 2015 through the end of 2019, market cap indexing outperformed fundamental indexing in the U.S. large cap market segment. However, over the same period, fundamental indexing outperformed market cap indexing in emerging markets.

    Furthermore, a closer look year by year would show how each form of indexing can lead in performance at different times as the market environment shifts. In U.S. large cap stocks, fundamental indexing underperformed market cap indexing in 2019, but it significantly outperformed in 2016. And in emerging markets stocks, fundamental indexing outperformed market cap indexing in both of those years.

    Combining both forms of indexing within a portfolio is designed to help enhance overall diversification as the market environment shifts over time and different investment styles move in and out of favor.

    Figure 1: Diversification benefits of fundamental indexing

    A bar chart showing potential diversification provided by combining fundamental indexing and market cap indexing. US Large Cap Stocks, Fundamental Index around 10%, U.S. Large Cap Stock Market Cap Index around 12%. Emerging Market Stocks, Fundamental Index around 8%, Emerging Market Stocks, Market Cap Index around 5%.

    Source: Morningstar Direct, 4/1/2015 – 12/31/2019. Indexes used are the Russell RAFI US Large Company Index vs. the S&P 500® Index and the Russell RAFI Emerging Markets Index vs. the MSCI Emerging Markets Index.

    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.

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

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

    FTSE Russell and Research Affiliates LLC have entered into a strategic alliance with respect to the Russell RAFITM Index Series. Subject to Research Affiliates' intellectual property rights in certain content, FTSE Russell is the owner of all copyrights related to the Russell RAFITM Index Series. FTSE Russell 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 FTSE-Russell or Research Affiliates.

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

    Please read the Schwab Intelligent Portfolios Solutions™ disclosure brochures for important information, pricing, and disclosures related to the Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium programs.

    Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are made available through Charles Schwab & Co. Inc. ("Schwab"), a dually registered investment advisor and broker dealer. Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. ("CSIA"). Schwab and CSIA are subsidiaries of The Charles Schwab Corporation.

    (0220-0Z1W)


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