New Fundamental ETFs Broaden Field

IndexUniverse.com

I concede there’s little that’s radically new in Schwab’s recent launch of six new fundamental funds . After all, ETF investors have clearly bought into the fundamental approach as shown by the more than $2 billion in the PowerShares FTSE RAFI US 1000 (PRF).

What’s more, the index methodology powering PRF was developed by the same firm—Research Affiliates—that’s behind the new Schwab funds.

Still, in my view, this is good news for investors. Schwab brings its distribution muscle to the new funds—muscle that’s proved to be quite effective at gathering assets and liquidity, judging from Schwab’s existing lineup of capitalization-weighted ETFs.

True, the new fundamental funds won’t come with the incredibly low expense ratios that Schwab’s cap-weighted ETFs have, and that doubtless have added to their popularity.

At 32 basis points, or $32 for each $10,000 invested, the fundamental ETFs are far more expensive than the cheapest cap-weighted products, though they still undercut PowerShares’ suite of fundamental funds, which cost 39 basis points. The point is that the outlook for investor interest—a vital ingredient for any fund you want to be a part of—is strong.

Fundamental Vs. Cap-Weighted

The new suite of funds broadens the choices for fundamental exposure in an ETF. Russell Investments, which has partnered with Research Associates to create the indexes behind the Schwab funds, describes the fundamental indexes as an alternative to active investing.

My take is slightly different; namely, that the fundamental approach should be compared with cap-weighted indexing—the gold standard—not with active management, a nebulous point of reference.

In a nutshell, fundamental indexes take positions in firms relative to their economic footprint, not by the market value of their equity. Specifically, the indexes under the Schwab funds look at three things:a firm’s top line (sales, adjusted for leverage); bottom line (cash flow, not earnings); and how much cash is returned to equity holders (dividends and buybacks).

What’s missing from this trio of metrics? Share price. Cap-weighted indexes—the pure-play of passive indexing—measure firm size by the market value of equity:share price multiplied by free-float shares outstanding.

This approach captures the aggregate size that market participants place on the firm. Fundamental-istas might argue that it captures firm size based on the inputs of overly active short-term players, and therefore misses the mark at times.

 

 

 

Fundamental Vs. Style

Share price also plays a role in style investing, because firms are placed on the value and growth continuum based on the relationship of share price to earnings and to the book value of equity.

This distinction matters, because fundamental investing is often seen as a cousin to value investing. In shorthand, fundamental investing does away with the “price” numerator in the price/earnings (P/E) and price/book (P/B) ratios that underpin value investing.

By removing price from the equation, fundamental indexes don’t attempt to find “undervalued” stocks as do value indexes. Yet fundamental indexes retain some of the spirit of value investing by favoring firms whose large economic footprints tend to have a bigger denominator in style ratios, which in turn make the P/E and P/B ratio smaller and more valuelike.

Contrarian Overtones

To me, the removal of price from the process of weighting holds an emotional appeal.

I like the idea of not hopping on the bandwagon as the latest hot stock scales to lofty peaks only to tumble back to Earth. Similarly, I like being a bit insulated from the latest short-selling hedge fund manager trying to talk a stock down.

Of course, firms grow and shrink organically and don’t always do so in an orderly fashion, but fundamental indexes hold the promise of avoiding the worst of the herd mentality.

I don’t mean to say these are low-volatility products. They’re not. But the indexes under Schwab ETFs use a five-year average for the three selection and weighting metrics, so they don’t run with the crowd.

In effect, they take a contrarian view­ ­ —another similarity with value investing—and will sell off the hottest stocks and buy the plunging ones at each rebalancing.

Speaking of rebalancing, Russell uses rolling quarterly rebalance for these funds. In short, a portion of the portfolio will rebalance to the annually reset target every three months. The idea is to find the best balance between the costs and benefits of keeping a portfolio—which, after all, moves with share prices, even though they’re excluded from selection and weighting process—in line with the intended exposure.

This approach demonstrates the expertise in day-to-day index management that Russell brings to the Russell/ Research Affiliates partnership here.

As with all new funds, use care if trading the Schwab Fundamental ETFs in the early days.  While Schwab clients avoid commissions on the trade, they’re not protected from transaction costs related to bid/ask spreads. Check intraday NAV, use limit orders and seek help from a liquidity provider or from Schwab’s capital markets desk for larger trades.

 


 

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at pbritt@indexuniverse.com.

 

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