When it comes to most stock indexes, bigger is better. The widely followed S&P 500, and other popular market indexes, use market capitalization as their primary weighting factor, with bigger companies getting more weight in their respective indexes than smaller companies.
But one branch of investing philosophy believes that market capitalization isn't the ideal way to create a portfolio. Instead, proponents of fundamental-strategy investing prefer to look at factors that are more closely connected to a company's business performance. Recently, Charles Schwab (NYSE:SCHW) became the latest ETF company to embrace fundamental investing, debuting six new exchange-traded funds. These six ETFs all track indexes created by indexing giant Russell Investments, and they share a methodology that alternative-index pioneer Rob Arnott helped develop. Let's take a closer look at the ETFs and why they might bring better results than traditional index investments.
Fundamentally better ETFs?
The idea behind Schwab's new fundamental index ETFs is simple: rather than tracking market capitalization, the ETFs choose and weight their respective components based on a combination of other factors. For instance, the Schwab Fundamental U.S. Broad Market ETF tracks Russell's Fundamental U.S. Index, weighting components by their retained operating cash flow, their adjusted revenue, and the total money they return to shareholders in the form of both dividends, and share buybacks.
The net impact of this method is to give much-loved high-growth companies that don't yet have the revenue and cash-generating capabilities to justify their elevated stock prices less weight than well-established, slower-growth companies that already have plenty of earnings and cash flow. Just looking at the holdings of the U.S.-based Schwab fundamental ETF makes the differences clear, as three of the four top-weighted companies in the index are energy companies ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), and ConocoPhillips (NYSE:COP) -- slow- to no-growth companies that bring in cash hand over fist. Telecom giant AT&T (NYSE:T) also comes in strong at No. 3, thanks largely to the huge cash flow its existing telecom network generates, and the big dividends and buybacks its cash flow helps support.
A growing trend
Schwab isn't the only company to embrace fundamental investing. Invesco's PowerShares has used fundamentally weighted ETFs in the past, and those ETFs have shared the benefits of avoiding overconcentration in highly valued stocks that have subsequently fallen from grace.
The difference here, though, is that Schwab already has strong relationships with many registered investment advisors. The brokerage company hopes to use those relationships to bolster sales of the ETFs, which include exposure not just to large-cap U.S. stocks, but to smaller companies and stocks in international markets, as well.
Should you buy in?
It's hard to argue against investing in companies that produce ample cash flow and revenue, and then use it to return unneeded capital to shareholders. From year to year, fundamental indexes and traditional market-cap-weighted indexes are likely to take turns leading the market higher or lower. Only time will tell whether these indexes will produce the long-term outperformance that they'll need to achieve in order to overcome the slightly higher 0.32% expense ratio they charge their shareholders.