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An unconventional play on U.S. value stocks

This fundamentally weighted ETF allows investors to profit from mean reversion in valuations.

Alex Bryan 29 March, 2016 | 5:00PM
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 Schwab Fundamental U.S. Large Company ETF (FNDX) is an unconventional value index strategy that should do well relative to other U.S. large-cap value funds over the long term. It tracks the Russell Fundamental U.S. Large Company Index, which offers broad exposure to large- and mid-cap U.S. stocks but weights its holdings based on fundamental measures, rather than market capitalization. These include size (as measured by sales, adjusted for leverage), retained operating cash flow, and dividends plus share buybacks.

This causes the fund to overweight stocks trading at low multiples of these metrics and underweight stocks trading at higher valuations. At times, these active weightings can add up to sizable sector bets. The fund currently has less exposure to the financial services and real estate sectors than the Russell 1000 Value Index, and greater exposure to telecom, consumer defensive and cyclical stocks.

When it rebalances each quarter, the fund trims positions in stocks that have become more expensive relative to their peers and increases its exposure to those that have become cheaper during the past year. These disciplined bets against the market may give the fund an edge against its market-cap-weighted value index peers if and when valuations revert to the mean. 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.

In order to reduce the market impact cost of rebalancing and the risk of poor timing, Russell divides the index's portfolio into four equal slices and rebalances a different slice each quarter. This approach is a notable improvement over the fund's closest competitor,  PowerShares FTSE RAFI U.S. 1000 ETF (PRF), which rebalances the entire portfolio on one day each year.

This fund may be a suitable core holding for long-term investors who can stomach a little extra volatility to profit from potential market mispricings or a risk premium associated with lower valuations. Over the long run, betting on value has paid off in nearly every market studied. Investors may extrapolate past growth--or lack thereof--too far into the future, which can push prices away from fair value. Fundamental weighting counters this bias by removing the link between market prices and portfolio weightings.

Schwab charges a competitive 0.32% expense ratio for this fund. While there are cheaper market-cap-weighted value index funds available, this fee is slightly lower what PRF charges (0.39%).

Fundamental View

According to a paper by Morningstar's Paul Kaplan, titled Why Fundamental Indexation Might--or Might Not--Work, fundamental indexes make the implicit assumption that all holdings should trade at the same fair value multiples. However, different levels of risk and growth could justify different fair value multiples, which may cause a fundamental index to misrepresent a firm's true fair value in its weightings. Market prices reflect differences in risk and expected growth, but--as the proponents of fundamental indexing argue--market prices are noisy and may diverge from fair value. Kaplan asserts that in order for a fundamental index to be superior to a market-cap index, market valuation errors would need to be more variable than differences in the justified fair value multiples. This may be the case for stocks at the extremes of the valuation spectrum (deep value and high growth).

Market prices don't need to be wrong for fundamental indexing to offer a return advantage. The market may correctly assign lower valuations to riskier stocks so that they offer higher expected returns as compensation. Fundamental indexes may collect a risk premium for overweighting these stocks. Regardless of whether risk or mispricing is responsible, value stocks have historically outpaced the market over the long run. Because the fund gives an overweighting to these stocks, it should follow a similar return pattern. Overall, the fund has a similar market cap and value orientation to the Russell 1000 Value Index.

There is nothing special about the weightings that fundamental indexes employ. In a provocative paper titled The Surprising Alpha From Malkiel's Monkey and Upside-Down Strategies, Rob Arnott, the CEO of Research Affiliates (which developed the methodology for the index this fund tracks), and his colleagues found that many non-market-cap-weighted strategies, including fundamental weighting, outperformed the market-cap-weighted benchmark. They then flipped the weightings of these portfolios around so that the smallest constituents received the largest weightings. These inverse portfolios also outperformed the market-cap benchmark and, in many cases, the original strategies. The authors argue that the success of both the original strategies and their inverses is due to their implicit tilts toward small-cap and value stocks.

The fund's disciplined rebalancing approach may give it an advantage over market-cap-weighted value index funds. In order to rebalance back to its fundamental weightings, the fund buys stocks that have become cheaper since the previous rebalance and reduces exposure to those that have become more expensive. This approach should boost returns if valuations mean revert. The fund has not yet amassed a significant live performance record, as it was launched in August 2013. During the past decade (a period that includes back-tested data), its benchmark outpaced the Russell 1000 Value Index by 2.5 percentage points annualized, with comparable volatility.

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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.

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