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Schwab Founder: Indexing Is Not Passive

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Charles Schwab, founder of the investment firm bearing his name, decried the bad rap index funds get as “passive” investments, arguing that the commonly used nomenclature fails to capture the dynamic nature of the investment strategy.

In a media call Thursday that was unusual for the chairman’s personal participation, Schwab emphasized that “nobody wants to be passive; indexing is not passive — much more goes into indexing than watching a stock become the next buggy whip.”

Further disavowing the notion that indexing is compatible with outmoded corporations, he added that “20 years ago we didn’t have Facebook; today they’re in the index because of the innovation of the American economy.”

Indeed, the Silicon Valley-based social media giant entered the Schwab 1000 index in 2013, the same year that Molycorp — as stock whose valued had declined 80% — lost its eligibility to remain in the firm’s index of the thousand largest U.S. companies in terms of market cap.

That point was one of many made in a whitepaper whose release was timed for Schwab’s media appearance.

Titled The Wealth-Building Power of Equities and the Elegance of Indexing, the new whitepaper serves as a primer on the principles of indexing that Schwab said was self-consciously written with the average investor in mind, breaking no new ground on the subject, but explaining indexing in terms the Schwab Corp. chairman hoped would “help the average investor understand this magic, what it is really about.”

To that end, the paper starts with the basic point that investing in stock, as opposed to bonds or cash, uniquely provides growth — a benefit that ordinary investors have difficulty accessing because of the challenge of choosing and sticking with appropriate investments.

Those challenges include identifying skilled managers and the risk that even good actively managed funds cannot overcome the burden of high costs and portfolio turnover-induced taxation.

But a recurring theme in both the paper and the call was indexing’s image problem.

As Schwab writes in a letter introducing the whitepaper, “the word passive does a disservice to investors considering their options. Indexing provides an effective means of owning the market and allows investors to participate in the returns of a basket of stocks. The basket of stocks changes over time as stocks are added or removed based on its rules.”

And on the call, Schwab put it this way:

“There’s a reputation that index funds are static. That’s not really true. In the case of the Schwab 1000 index, about 5% of the index is changed every year. It does change over time. And the outcomes have been every bit as good as some of the active funds, particularly on an after-costs and after-tax basis.”

Indeed, the Schwab 1000 Index, which Schwab launched in April 1991, has enjoyed compounded growth of more than 700% through the end of last year, for an annualized return of 9.8% (or 9.4% in the Schwab 1000 Index Fund, which tracks the index).

Those returns were achieved through a rules-based methodology determining annually when securities were to be added or deleted and how securities were to be weighted — as well as the fund’s very low 0.30% annual management fees.

Together with tax-loss harvesting that reduces taxable distributions and relatively low turnover rates compared with active funds, an investor not able or not interested in selecting investments would have seen a $1,000 investment in 1991 turn to over $7,000 through this dynamic process, in which fund owners are essentially “making the market their manager.”

The bottom line, as the whitepaper adds, is that “index funds have done well on both an absolute and a relative basis: on an absolute basis over the long term because equity markets have grown over time, and on a relative basis because of their lower cost structures.”

While indexing thus generates returns consistently superior to those of active managers, who only rarely repeat top performance according to studies the paper cites, indexing shows signs of actually improving through an evolution of the strategy known variously as “smart beta” or “fundamental indexing.”

Fundamentally weighted indexes screen and weight stocks based on factors such as price-to-sales, buybacks and other economic factors rather than weighting a portfolio based on stock-market capitalization, which critics say biases a portfolio to popular, expensive stocks.

Speaking on the call, Schwab praised this new type of indexing:

“I think they’ll be superior. For new money going in, I think fundamental investing is certainly a preferred way to go,” noting however that he wouldn’t sell his own money long invested in a market-cap-weighted index to avoid generating capital gains on the sale.

One potential advantage of the smart beta approach is that it “prevents extraordinary things — like when one or two companies dominate market,” Schwab said.

He illustrated the point by citing Apple, which rose to the top spot in the Russell 1000 index but didn’t even make the top 10 in a fundamentally weighed version of that portfolio, thus advantaging investors when Apple’s stock crashed (though hurting those same investors when Apple’s stock surged).

So why was the chairman on a media call explaining the advantages of indexing?

“People are coming back in market in 2014,” he said, noting the long hiatus retail investors have taken since the financial crisis.

And while they’re shopping for investments, the Schwab chairman wanted investors to understand that indexing — of whatever type — is a dynamic approach they can embrace.

“All index funds have proven themselves,” he said.

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