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.
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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.