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Finding the Right Fit for Fundamental Indexing

Michael Rawson, CFA

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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Rawson: So it's the rebalance. Now I think it's interesting that a lot of these sound very new to some people who are familiar with indexing or familiar with active strategies, but this fundamental or smart beta sounds new. But it's actually been out for a little bit over five years now. Some of these are real-world funds, so it's not back-tested, it's not back-filled. This is real data, and some of these funds have done quite well. There is a PowerShares Fundamental fund out there. Guggenheim, as you are well aware, has an equal-weighted fund that has performed well.

Schwab actually got into this space five years ago with some mutual funds. Now, recently though, you did launch some ETFs following these strategies. Now that was at Schwab. I do want point out technically, although you work for Schwab, you are actually with Schwab Center for Financial Research, is that correct?

Davidow: Correct.

Rawson: Could you describe what is the Center for Financial Research?

Davidow: The Schwab Center for Financial Research is an independent think-tank within Schwab, where I am really charged with representing Schwab clients and articulating and developing points of view on things like asset allocation and portfolio construction, the views on active and passive strategies. And ultimately you’ll start to see a lot more research coming from us on how to incorporate and use alternative investments in client portfolios. Similar to Liz Ann Sonders or Kathy Jones, we are independent in providing thought leadership to our clients, without having a product affiliation.

Rawson: If I have a portfolio, maybe I follow Morningstar and maybe I'll follow the recommendation and combine passive and active together. I might have a core portfolio built with index funds and then sprinkle in some active funds on top of that, maybe some Gold-rated funds at Morningstar, or with some active managers who are going to take some big bets. Where does fundamental indexing fit into that?

Davidow: That's a great question because I think a lot of product providers often approach this and say, "It's my way or the highway." In our view there is a role for active and passive strategies, and we've actually done a fair amount of research on it and written white papers, where we believe there is a value in active and passive strategies, and then we further delineate passive strategies into fundamental and market-cap even though you're dealing with a very similar eligible universe of securities that can go into an index. Because of the different weighting methodologies, they perform quite differently over time, and what we've seen is one complements the other.

Frankly, we do believe there is a role for active. I know everyone wants to talk about the demise of active management, but we love active management when markets get choppy, because as much as we enjoy the experience you get with an index-based product, you can't deviate from that rules-based process. So if there's an exogenous event or something happens around the world, an active manager can, in fact, be more nimble, more adaptable, and change to that environment. We think the combination actually provides a more durable portfolio and hopefully serves our clients’ needs better in the long run.

Rawson: Tony, I appreciate those insights. Thank you for joining me today.

Davidow: Thanks for having me.

Rawson: For Morningstar, I’m Mike Rawson.