An Unconventional Play on Value

When it rebalances each quarter, the fund trims positions in stocks that have become more expensive relative to their peers and increases its exposure to those that have become cheaper during the past year. These disciplined bets against the market may 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 to detect souring prospects than market prices.

In order 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. This approach is a notable improvement over its closest competitor,

This fund may be a suitable core holding for long-term investors who can stomach a little extra volatility to profit from potential market mispricings or a risk premium associated with lower valuations. Over the long run, betting on value has paid off in nearly every market studied. Investors may extrapolate past growth--or lack thereof--too far into the future, which can push prices away from fair value. Fundamental weighting counters this bias by removing the link between market prices and portfolio weightings.

Fundamental View According to a paper by Morningstar's Paul Kaplan, "Why Fundamental Indexation Might--or Might Not--Work," fundamental indexes make the implicit assumption that all holdings should trade at the same fair value multiples. However, different levels of risk and growth could justify different fair value multiples, which may cause a fundamental index to misrepresent a firm's true fair value in its weightings. Market prices reflect differences in risk and expected growth, but--as the proponents of fundamental indexing argue--market prices are noisy and may diverge from fair value. Kaplan asserts that in order for a fundamental index to be superior to a market-cap index, market valuation errors would need to be more variable than differences in the justified fair value multiples. This may be the case for stocks at the extremes of the valuation spectrum (deep value and high growth).

Market prices don't need to be wrong for fundamental indexing to offer a return advantage. The market may correctly assign lower valuations to riskier stocks so that they offer higher expected returns as compensation. Fundamental indexes may collect a risk premium for overweighting these stocks. Regardless of whether risk or mispricing is responsible, value stocks have historically outpaced the market over the long run. Because the fund gives an overweighting to these stocks, it should follow a similar return pattern. Overall, the fund has a similar market cap and value orientation to the Russell 1000 Value Index.

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 methodology for index 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 due to their implicit tilts toward small-cap and value stocks.

The fund's disciplined rebalancing approach may give it an advantage over market-cap-weighted value index funds. In order to rebalance back to its fundamental weightings, the fund buys stocks that have become cheaper since the previous rebalance and reduces exposure to those that have become more expensive. This approach should boost returns if valuations mean revert. The fund has not yet amassed a significant live performance record, as it was launched in August 2013. During the past decade (a period that includes back-tested data), its benchmark outpaced the Russell 1000 Value Index by 2.5 percentage points annualized, with comparable volatility.

Portfolio Construction The fund employs full replication to track the Russell Fundamental U.S. Large 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 largest 87.5% of the eligible universe go into the Russell Fundamental Global Large Company Index. The Russell Fundamental U.S. Large 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 only holds a small portion of each stock's floated shares.

Fees Schwab charges a competitive 0.32% expense ratio for this fund. While there are cheaper market-cap-weighted value index funds available, this fee is slightly lower what its closest competitor charges. It also compares favorably with actively managed funds in the category. Schwab engages in securities lending, which generates ancillary income that partially offsets the fund's expenses. During the trailing 12 months through February 2016, the fund lagged its benchmark by 31 basis points.

Alternatives

Investors can also get exposure to the index FNDX tracks in a mutual fund format through

PRF is the next closest alternative. Similar to FNDX, the index it tracks applies methodology developed by Research Affiliates. The PowerShares fund weights its holdings based on 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 FNDX's. But PRF 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 slightly higher 0.39% expense ratio. Therefore, FNDX is a little more compelling.

A dividend-weighted index fund, such as

Market-cap-weighted value index funds may also be good alternatives. Among these,

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