Schwab Founder: Indexing Is Not Passive

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.