An article from MarketWatch dismisses the latest fundamentally-indexed exchange-traded funds (ETFs) announced by Charles Schwab Investment Management as “different” as opposed to “better” mousetraps.
The question for investors is whether they are the rodent, getting snapped up by the contraptions that financial inventors are creating.
Catchy metaphors aside, according to a note from Reuters
San Francisco-based Schwab, long a leader in selling mutual funds to investors, already has five mutual funds based on fundamental indexing. Those five funds, which launched in 2007, had $4.5 billion in total assets under management as of June 30.
From Schwab’s website
Fundamental indexes use fundamental measures of company scale and success—such as adjusted sales, retained operating cash flow, and dividends + buybacks—to construct the indexes. These fundamental factors address the inherent bias of traditional indexes, which are based on market capitalization and can give too much weight to overpriced securities and too little weight to underpriced securities.
Hence the tilt towards value investing (i.e. higher weights of underpriced securities) inherent in these funds. While some research shows that fundamental investing can add a statistically significant value, apparently this is limited to a few specific indices and regions.
As the article states
Just as studies have shown that value investing holds a slight edge over growth investing over the long haul, fundamental investing has shown an ability to outperform its traditional cap-weighted peers, although that history is not long once you throw out back-testing (results “proven” by looking backward and seeing how the strategy might have performed had it existed years ago).
Since Schwab’s fundamentally-indexed mutual funds have been in existence for over six years now, and that period spanned a significant market downturn, it is worthwhile to take a look at their historical risk-adjusted performance, as measured by the trailing five-year Sharpe Ratio (all data from Morningstar):
|Schwab Fundamental Fund||Ticker||SR||Best-Fit ETF||Ticker||SR|
|US Large Company Index||SFLNX||0.60||iShares Russell 1000 Value||IWD||0.47|
|US Small Company Index||SFSNX||0.56||iShares Russell 2000||IWM||0.49|
|International Large Company Index||SFNNX||0.19||iShares MSCI EAFE Value||EFV||0.14|
|International Small Company Index||SFILX||0.37||iShares MSCI EAFE Growth||EFG||0.16|
|Emerging Markets Large Company Index||SFENX||0.13||iShares MSCI Emerging Markets||EEM||0.13|
In all cases, the Sharpe Ratio of the fundamentally-indexed fund was greater than or equal to that of the ETF that follows the best-fit index for the fund. While past performance does not guarantee future results, the above data certainly support the introduction of ETFs based on the same (and one more, the U.S. Broad Market) fundamental indices. They may be better mousetraps after all.