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This Dynamic Small-Cap ETF Should Find an Edge

Bronze-rated Schwab Fundamental U.S. Small Company ETF attempts to profit from mean-reversion in valuations among small-cap stocks. 

Alex Bryan, 03/20/2017

Schwab Fundamental U.S. Small Company ETF FNDA breaks the link between market prices and portfolio weightings, which injects a disciplined rebalancing approach that should give the fund an edge over its peers over the long term. This is a value strategy, though it falls in the small-blend Morningstar Category. The fund recently cut its fee to 0.25% from 0.32%, which is reasonable. But its inconsistent exposure to value stocks and risk of overweighting stocks with deteriorating fundamentals limit its Morningstar Analyst Rating to Bronze.

This fund offers broad exposure to small-cap U.S. stocks but weights them on fundamental measures of size, including sales (adjusted for leverage), retained operating cash flow, and dividends plus share buybacks, rather than market cap. This causes the fund to tilt toward stocks trading at low multiples of these metrics and away from stocks trading at higher valuations. However, it does not exclude growth stocks.

When it rebalances each quarter, the fund trims positions in stocks that have become more expensive relative to peers and increases its exposure to those that have become cheaper during the past year. These disciplined bets against the market should give the fund an edge against its market-cap-weighted value index peers if and when valuations mean-revert. However, this approach can also increase the fund's exposure to stocks with deteriorating fundamentals. This is because the metrics that determine the weightings of the fund's constituents are backward-looking and are usually slower than market prices in detecting souring prospects. To reduce the market-impact cost of rebalancing and the risk of poor timing, the fund refreshes a different fourth of its portfolio each quarter.

So far, this approach has worked well. The fund outpaced the Russell 2000 and Russell 2000 Value indexes by 1.5 and 0.9 percentage points annualized, respectively, from inception in August 2013 through February 2017. This was partially thanks to more-favorable stock exposure in the industrials sector.

Fundamental View
Fundamental weighting is inherently a value strategy. Over the long run, betting on value has paid off in nearly every market studied. There are two plausible explanations. First, value stocks may be riskier than growth stocks and priced to offer higher returns as compensation. Alternatively, investors may extrapolate recent growth--or lack thereof--too far into the future, which can push prices away from fair value. In reality, both of these effects are probably at work. Either way, the fund should benefit when value stocks outperform, because its fundamental-weighting approach tilts the portfolio toward stocks trading at low price multiples.

There is nothing special about the weightings that fundamental indexes employ. In a provocative paper titled, "The Surprising Alpha From Malkiel's Monkey and Upside-Down Strategies," Rob Arnott, the CEO of Research Affiliates (which developed the index that this fund tracks), and his colleagues found that many non-market-cap-weighted strategies, including fundamental weighting, outperformed the market-cap-weighted benchmark. They then flipped the weightings of these portfolios around so that the smallest constituents received the largest weightings. These inverse portfolios also outperformed the market-cap benchmark and, in many cases, the original strategies. The authors argue that the success of both the original strategies and their inverses is attributable to their implicit tilts toward small-cap and value stocks.

Market-cap-weighted value index funds offer similar exposure. But the fund's disciplined rebalancing approach should give it a small edge. In order to rebalance back to its fundamental weightings, the fund buys stocks that have become cheaper relative to their peers since the previous rebalance and reduces exposure to those that have become more expensive. This approach should help the fund more efficiently profit from mean-reversions in valuations, but it can also increase turnover and transaction costs. And fundamental weightings ignore potentially useful information contained in market prices.

This is a well-diversified portfolio that includes 800-plus holdings. While most of these stocks are also in the market-cap-weighted Russell 2000 Index, many of their weightings are quite different. For example, SkyWest SKYW and Cliffs Natural Resources CLF are both among the fund's top 25 holdings, while they fall outside the index's top 200. That's largely because they are trading at low multiples of sales, operating cash flows, and shareholder distributions relative to their peers, which makes their fundamental weighting larger than their market-cap weighting.

Alex Bryan is an ETF analyst with Morningstar.

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