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By Michael Rawson, CFA | 09-10-2013 12:00 PM

Finding the Right Fit for Fundamental Indexing

Schwab's Tony Davidow says active factor-based investment strategies complement passive index strategies to help enhance portfolio durability over time.

Mike Rawson: Hi. I’m Mike Rawson with Morningstar. Fundamental indexing and smart beta strategies have been all the rage in exchange-traded funds lately. Joining me today to talk about fundamental indexation is Tony Davidow. Tony is a strategist with Charles Schwab.

Tony, thanks for joining me.

Tony Davidow: Thanks for having me, Mike.

Rawson: Tony, these terms fundamental indexing, smart beta--how do we think about these funds? Are they passive; are they active? What should we be aware of when we are investing in these types of funds?

Tony Davidow: That's a great question because there are a fair number of strategies in the market, and if you think from a macro perspective, smart beta, or alternative beta, essentially are strategies that are other than market-cap or nontraditional weighted strategies. Then underneath the family of smart beta or alternative beta, you have strategies like equal weight, fundamentally weighted, low-volatility, and mean-variance type strategies. I think it's important to understand they are different. There are differences in the way they are constructed, but essentially what they are doing is they are giving a non-cap exposure to the markets.

Rawson: Non-cap. So why is that good? Why would I want non-cap exposure?

Davidow: It's just different. I think as you and your colleagues have covered well, market-cap strategies essentially are making a bet at the biggest companies or the best companies, market-cap indexes--the S&P 500, the Russell 1000--most of the major indexes are market-cap oriented, which means they are making a bigger bet on the biggest companies. The biggest companies have the biggest weightings. Fundamental strategies in particular seek to weight securities based on economic factors. So by screening and weighting securities differently, you have a different weighting composition, which ultimately leads to different results over time.

Rawson: We know that the index is hard to beat. A lot of active managers over time fail to beat the market-cap-weighted index. Here you are saying, the market-cap-weighted index might be hard to beat, but we can do it through an alternative-weighting methodology. How are we going to beat the index?

Davidow: Well, there is a lot of research done by firms like Research Affiliates, Russell, and EDHEC, and Cass Consulting that have shown a fair amount of persistence in fundamental strategies delivering excess return relative to the market-cap equivalent. It seems to be fairly persistent across geographies and up and down the capitalization spectrum. At Schwab, and specifically at the Schwab Center for Financial Research, we've actually done research on it, and we actually see outperformance coming from these strategies. It's really the reweighting of those underlying indexes as well as rebalancing, and we show that that has delivered excess return over time.

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