Bronze-rated Schwab Fundamental U.S. Small Company ETF attempts to profit from mean-reversion in valuations among small-cap stocks.
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 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.
At times, the fund's active weightings can add up to large sector bets. The fund currently has greater exposure to industrials and consumer cyclicals than the Russell 2000 Index and less exposure to healthcare stocks. Its holdings tend to trade at slightly lower average multiples of forward earnings than the constituents in the Russell 2000 Index. The portfolio also has a modestly larger market-cap orientation than that benchmark.
This is a well-crafted, fundamentally weighted strategy that systematically rebalances into stocks as they become cheaper relative to their peers, supporting a Positive Process rating.
The fund employs full replication to track the Russell RAFI US Small Company Index. The construction approach begins with the Russell Global Index. Russell screens out the least-liquid stocks from this index. It then assigns fundamental weightings to each remaining stock based on leverage-adjusted sales (sales times book equity/assets), retained operating cash flow, and dividends plus share repurchases. Russell uses the five-year average for each metric and takes the average of the resulting three values to determine each stock's fundamental size. Stocks representing the smallest 12.5% of the eligible universe go into the Russell RAFI Global Large Company Index. The Russell RAFI US Small Company Index includes the U.S. stocks from this global index, and it weights each holding in proportion to its fundamental size. Russell divides the index's portfolio into four equal slices and rebalances a different slice each quarter. This approach helps reduce the market-impact cost of rebalancing and the risk of poor timing. As an additional precaution, the index limits its weightings so that it holds only a small portion of each stock's floated shares.
On March 1, 2017, Schwab cut the fund's fee to 0.25% from 0.32%, making this the cheapest fundamentally weighted fund in the category. Therefore, it earns a Positive Price Pillar rating. During the trailing 12 months through February 2017, the fund lagged its benchmark by 38 basis points, slightly more than the amount of its expense ratio.
PowerShares FTSE RAFI US 1500 Small-Mid ETF PRFZ is the closest alternative. It offers broad exposure to small stocks and applies slightly different metrics to weight its holdings. These include sales (without the adjustment for financial leverage), cash flow, dividends (where applicable), and book value. It uses the five-year averages of each metric, with the exception of book value, where it takes the most recent value. This set of weighting metrics is not clearly better or worse than FNDA's. But PRFZ rebalances its entire portfolio once each year, which can cause it to experience higher market-impact costs and more-abrupt portfolio changes. It also charges a higher 0.39% expense ratio but still carries an Analyst Rating of Bronze.
Bronze-rated WisdomTree SmallCap Dividend ETF DES (0.38% expense ratio) might be a more compelling fundamentally weighted alternative for investors looking for income. This fund weights each holding by the dollar value of dividends it is expected to pay out during the next year relative to the aggregate projected dividend payments from all the stocks in the fund. This approach gives DES a higher dividend yield and a stronger value orientation than FNDA.
Silver-rated Vanguard Small-Cap Value ETF VBR (0.08% expense ratio) is one of the cheapest small-cap value strategies available. It targets stocks representing the cheaper half of the U.S. small-cap market and weights them by market cap. Unlike FNDA, it excludes growth stocks and allows market prices to determine the composition of the portfolio. But it should have lower transaction costs.
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