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Schwab Marries Strategic Beta, Market-Cap Strategies

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Charles Schwab has the rather unique belief that fundamental index and cap-weighted strategies are highly complementary, according to a recent conference call held by Schwab. 

At Schwab, they believe it’s not a matter of either-or but of both.

Tony Davidow, alternative beta and asset allocation strategist for the Schwab Center for Financial Research, discussed the role that fundamental index strategies can play in a portfolio and how they can complement market-cap strategies.

“We’ve been very vocal on the point that we believe there’s a role for active, market cap and fundamental index strategies in building portfolios,” Davidow said during the conference call.

Most of the major indexes (such as the S&P 500, Russell 1000, Russell 2000 and MSCI EAFE indexes) are market-cap weighted, meaning that the largest companies by market capitalization — the number of outstanding shares multiplied by share price — have the largest weight in the index, creating a large-cap bias.

Meanwhile, fundamentally weighted indexes — a “smart beta” or, in Schwab parlance, a strategic beta strategy — screen and weight companies based on economic factors such as sales, cash flow and dividends plus buybacks.

As Davidow described fundamental index strategies, “The companies that exhibit strong fundamental characteristics get the largest weight in the fundamental index and in fact many of the best active managers seek to employ strategies similar to this. The difference of course is fundamental index ETFs aim to deliver this in disciplined rules-based fashion.”

Davidow has some suggestions on how investors can build portfolios using both market-cap indexing, fundamental indexing and active strategies. Davidow recommends looking at “four key levers” to identify how to build these portfolios: tracking error, loss aversion, alpha and cost.

“Market cap indexes typically provide the lowest cost wave of owning a market segment; they have little to no tracking error relative to their benchmark — however, when the market falls they will likely fall in lockstep with the market,” he said. “Fundamental indexing strategies provide the potential for alpha, and I think that’s where a lot of their appeal has come. … Active management, we believe, has the potential to help deal with one of the big concerns we hear from clients, which is loss aversion. Active managers can play defense when it’s prudent to do so.” Schwab has what Davidow calls “a unique point of view” of allocating across these strategies. Using the four key levers, Schwab has developed a framework for building portfolios with these strategies.

“In the most efficient markets — think of domestic large cap — we would recommend a 50% allocation of fundamental, 30% to market cap, and 20% to active management,” Davidow said. “In the least efficient markets — think of emerging markets — we would recommend allocating 50% to active, 30% to fundamental and 20% to market cap. Based on each investor’s view of the market environment, they can easily alter or customize these allocations, but we think the combination of the levers and the framework we’ve suggested are instructive and helpful for investors and advisors.”

Schwab Intelligent Portfolios, its new automated investment advisory service, draws on more than 50 cap-weighted and fundamentally weighted ETFs in its portfolio. David Koenig, chief investment strategist at Schwab Wealth Investment Advisory, explained how Fundamental Index ETFs are used in Schwab Intelligent Portfolios.

“We think the use of fundamentally weighted ETFs is important and notably unique – because it offers a level of sophistication you can’t get through other automated investing services,” Koenig said on the conference call. “And we’re confident that the potential outperformance of the fundamental methodology should be enough to offset the moderately higher expenses of those ETFs over time.”

The Schwab Intelligent Portfolios platform offers both market-cap weighted and fundamentally weighted ETFs.

“Market-cap weighted ETFs and fundamentally weighted ETFs, they do tend to perform differently in different market environments and over time,” Koenig explained. “So by including both market cap weighted and fundamentally weighted ETFs in Schwab Intelligent Portfolios we’re actually able to add an additional level of diversification and potentially improve risk adjusted returns over time.”

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