Fundamentally Schwab

April 05, 2007

Chuck Schwab ties up the rights to the RAFI indexes for U.S. mutual funds.

Fundamental indexes have been one of the most provocative topics in the indexing world over the past couple of years. Big names have lined up on both sides of the aisle, either supporting or denigrating the theory, which holds that investors can achieve better returns with indexes that weight stocks based on "fundamental factors" (such as sales, revenues, dividends, etc.) rather than market capitalization.

This past Monday may have marked a turning point for the theory, however, as a significant new agreement promises to bring fundamental indexing to the masses.

On April 2, partners FTSE Group and Research Affiliates announced an deal with Charles Schwab Investment Management under which the investment firm will be the exclusive U.S. provider of open-end mutual funds based on the FTSE RAFI index series. PowerShares already offers a number of exchange-traded funds (ETFs) based on the indexes, but Schwab's broader reach will certainly help push the products deeper into public consideration.

The main voice promoting fundamental indexing these past few years has been Rob Arnott, chairman of Research Affiliates and the man behind the Research Affiliates Fundamental Index (RAFI), a precursor to the FTSE RAFI index series. Arguing that cap-weighted indexes reflect less the actual value of a stock than the biases and whims of investors, Arnott sought to create a more accurate representation of the market's value through his fundamental indexation methodology, which bases a company's weighting on its "fundamental value" as determined by sales, cash flow, book values and dividends. Weighting the indexes in this manner is supposed to prevent them from being dominated by overvalued, highflying stocks.

The FTSE RAFI indexes have outperformed other popular benchmarks on a backtested basis; on a real-time basis for the ETFs, the large-cap ETF (AMEX: PRF) has beaten its index since launch in December 2005, while the small-cap ETF (NDAQ: PRFZ) has slightly trailed its bogie. Still, not everyone is warm to the idea. Detractors include such indexing luminaries as John Bogle, Gus Sauter, Burton Malkiel and Bill Sharpe.

Some have said that fundamental indexing is too much like active management. They believe that indexes should represent as closely as possible the available investment opportunity set, and fear that, if an index is weighted by fundamentals instead of market cap, investors seeking to replicate the index could find it difficult to buy a smaller-cap stock that receives a heavy weighting based on its strong fundamentals. Others believe that a fundamentals-based index methodology inherently favors small-cap and value stocks, which have outperformed the overall market recently, but may not in the future.

The headline indexes in the FTSE RAFI series (and the underlying for two new Schwab funds) are the FTSE RAFI Developed ex US 1000 index and the FTSE RAFI US 1000 Index, both of which include the 1,000 companies with the highest fundamental value from the FTSE US All Cap Index and the FTSE Global All Cap Ex US, respectively. The corresponding Schwab funds are the Schwab Fundamental US Large Company Index Fund and the Schwab Fundamental International Large Company Index Fund.

Schwab will also roll of a third fund, the Schwab Fundamental US Small-Mid Company Index Fund, tracking the FTSE RAFI US Mid Small 1500 Index, which includes the mid- and small-cap constituents of the FTSE US All Cap Index. The mid/small index picks up where the FTSE RAFI 1000 index leaves off.

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