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A Better Mousetrap?

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Charles Schwab launched three new index funds April 2 that are based on fundamental indexes rather than cap-weighted indexes such as the S&P 500. Fundamentally weighted indexes base inclusion in the index on a company’s sales, cash flow, dividends, and book value, rather than on market cap, P/E, or valuation, according to the creator of these indexes, Robert Arnott, chairman of Research Affiliates, LLC, based in Pasadena, California.

The funds are based on three FTSE RAFI indexes. The new funds are: Schwab Fundamental U.S. Large Company Index Fund (SFLNX), based on the 1000 largest U.S. companies based on fundamental measures; Schwab Fundamental U.S. Small-Mid Company Index Fund (SFSNX), based on 1500 small- and mid-cap companies; and Schwab Fundamental International Large Company Index Fund, based on 1000 large companies in developed markets (ex-U.S.).

On a conference call announcing the launch, Charles Schwab, chairman and CEO of the eponymous San Francisco-based firm, who started his own cap-weighted index fund, the Schwab 1000, in 1991, said: “What we’re talking about today is really an innovation, a new mousetrap, essentially, that is simply better than our old version of indexing.” He adds that fundamental indexing is, “a much better way to go about indexing than I’ve ever seen before,” and expects that the early users of the fundamental index funds will be independent investment advisors, but that individual investors will also become interested in them as they become more well known.

Arnott says that fundamental indexing “mirrors the fundamental expectations of the economy rather than shifting expectations of investors.” Back testing of fundamental indexes over 45 years versus the S&P 500, which has been around for 50 years, showed that the fundamental indexes outperformed: “We’ve tested the idea back 45 years, and we’ve found over 200 basis points per annum of incremental return going back 45 years, value added in roughly seven out of 10 years.”

Perhaps even more importantly, the fundamental indexes “have shown historically higher returns than passive indexing with equal or slightly less risk,” than passive investing, according to Jerry Moskowitz, president of FTSE Americas.

There will be three classes of shares with different minimum investment amounts and expenses: at a $2,500 minimum investment, expenses will be 59 basis points; at $50,000 investment and above, 44 basis points; and at $500,000 and above, expenses drop to 35 basis points. Investment advisors can aggregate clients’ holdings to get the better expense treatment.