A contrarian small-cap ETF

This exchange-traded fund rebalances into stocks as they become cheaper relative to their fundamentals.

Alex Bryan 2 October, 2018 | 5:00PM

 Schwab Fundamental U.S. Small Company ETF (FNDA) features a contrarian rebalancing approach that should give the fund an edge over its peers over the long term. This is a value strategy, though it falls in the small-cap blend section of the Morningstar Style Box. While there is much to like about this strategy, its weighting approach may cause it to overweight stocks with deteriorating fundamentals, and it charges more than market-cap-weighted value alternatives, limiting its Morningstar Analyst Rating to Bronze.

This fund offers broad exposure to small-cap U.S. stocks but weights them on fundamental measures of size, including sales (adjusted for leverage), retained operating cash flow and dividends plus share buybacks, rather than market capitalization. This causes the fund to tilt toward stocks trading at low multiples of these metrics and away from stocks trading at higher valuations. However, it does not exclude growth stocks.

When it rebalances each quarter, the fund trims positions in stocks that have become more expensive relative to peers and increases its exposure to those that have become cheaper in the past year. These disciplined bets against the market should give the fund an edge against its market-cap-weighted value index peers if and when valuations mean-revert. However, this approach can also increase the fund's exposure to stocks with deteriorating fundamentals. This is because the metrics that determine the weightings of the fund's constituents are backward-looking and are usually slower to detect souring prospects than market prices. To reduce the market-impact cost of rebalancing and the risk of poor timing, the fund refreshes a different fourth of its portfolio each quarter.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.