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

 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.

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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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