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Schwab Cooks Up Smart Beta Hybrid

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One small step for Charles Schwab, and another leap forward for smart beta.

The metaphor is mixed, but it seems to fairly signal a significant new endorsement for an alternative indexing strategy that has been gaining ground by leaps and bounds.

So-called smart beta’s latest advance comes from Charles Schwab Investment Management (CSIM), one of the nation’s largest asset managers, which earlier this year changed the formula of its popular MarketTrack Portfolios to include an allocation to fundamentally weighted indexes.

CSIM has offered investors four MarketTrack funds — all-equity, growth, balanced and conservative — since 1995.

But in January the asset manager shifted the heretofore 100% cap-weighted index funds to a blend including a 30% to 35% allocation to smart beta. The result is a first-of-its-kind hybrid cap-weighted/smart beta product.

Given the MarketTrack funds’ $2 billion size, the switch implies a $600 million-plus shift into the burgeoning smart-beta space, which recent estimates have put at $360 billion.

The reason for the move?

“Fundamentally weighted indexing over the longer term has outperformed cap-weighted indexes,” John Sturiale, who leads CSIM’s product management team, tells ThinkAdvisor in a phone interview.

If smart beta outperforms, as proponents such as Rob Arnott’s Research Affiliates have long been saying, then why not allocate 100% of the funds’ investments to fundamental indexing?

Answers Sturiale: “No. 1, we can’t forecast the future. No. 2, investors should be cost conscious, and cap-weighted indexing allows you to [minimize] costs.”

In short, Schwab believes the two strategies that many view as competing with one another are complementary—that investors can actually improve their portfolios’ risk-return characteristics by combining them.

“The beauty of cap-weighted is the fact that it’s low cost and will track the market,” Sturiale says. “But one downside of cap-weighted is that the size of the company and number of shares outstanding are going to dominated by the biggest companies in that index — companies like Apple and Exxon Mobil — but we still believe in them and that’s why we have a weighting to them.

“Fundamentally weighted indexing is more expensive,” Sturiale continues, “but also allows us to use other factors like price-to-sales or dividends to weight the portfolio so that the size of the companies and number of shares outstanding don’t necessarily dominate the performance of that index.

“In different time periods, cap weighted will outperform and at other time periods, the fundamentally weighted will outperform; they’re both good strategies, both are cost effective, so why not combine them in a portfolio that over long periods should outperform either one and smooth out the volatility of either one?” he says.

In other words, the cap-weighted component keeps costs down and keeps in the investments tracked to benchmarks while the lower allocation to smart beta boosts returns and the MarketTrack package provides a low-cost vehicle (the four funds are all in the 60-basis point range) to hold the investments.

A recent Schwab white paper offers more of the investment theory behind the combo product, including analysis suggesting that smart beta and cap-weighted indexes perform better at different times, thus enhancing the funds’ risk characteristics.

Crucially, the MarketTrack Portfolios are also periodically rebalanced to stay aligned with their objectives.

The hybrid product is CSIM’s big product initiative for 2015, with Sturiale anticipating no new products on the immediate horizon.

“The thing about Schwab is we’re always listening to our customers to see what might be of value to them…We’re pretty diligent about when we roll things out; we want to make sure we’re rolling products out that our clients want to use,” he says.

The investment management exec sees three areas of current growth — in cap-weighted ETFs; fundamental strategies (Schwab offers six standalone fundamental ETFs and six standalone fundamental mutual funds, in addition to the four MarketTrack funds); and in target-date funds.

“What we like to do here at Schwab is provide choice for our clients…advisors can pick those ingredients [i.e., the standalone products] and put them together in ways appropriate for their clients,” says Sturiale, who oversees CSIM’s $260 billion in assets under management.

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