New Fundamental Index Funds On The Way

January 28, 2008

Schwab Planning To Expand Current Roster As Well As Enter Enhanced Funds 

Fundamental indexers are about to get a lower-costing alternative. But it won't be in the form of exchange-traded funds (ETFs).

On Thursday, Charles Schwab & Co. plans to launch two new index mutual funds based on Rob Arnott's fundamental benchmarking system. Those will compete against ETFs offered by PowerShares and using the same indexes created by Arnott's Research Affiliates.

Instead of relying on market-cap sizes to determine weightings, fundamental indexes use different business fundamentals to develop and create fund portfolios.

"Investors pre-select either to use ETFs or mutual funds. Most investors have a strong preference for one or the other. So it makes sense to have these strategies available in both forms," said Arnott.

But other reasons exist as well. "Of course, ETFs can't be offered in different share classes," Arnott said.

The new Schwab Fundamental International Small-Mid Company Index Fund (SFIVX) will come with an investor share class expense ratio of 0.64% per year. It will mirror the same benchmark as the PowerShares FTSE RAFI Developed Markets ex-U.S. Small-Mid Portfolio (AMEX: PDN), which charges 0.75%.

"We certainly take a look at the marketplace and different price points. ETFs certainly are a consideration in our pricing decisions," said Mike Bonardi, Schwab's director of investment management services.

The Schwab Fundamental Emerging Markets Index Fund (SFEMX) also will feature a lower expense ratio (0.84%) for most investors. The rival FTSE RAFI Emerging Markets Portfolio (AMEX: PXH) charges 0.85%.

The cost differences really become pronounced when comparing Schwab's two other share classes it plans to offer.

For a minimum purchase of $50,000, select shares will be sold for each fundamental mutual fund. At those levels, costs will drop 15 basis points. In the case of SFIVX, the expense ratio will fall to 0.64%. In the other new Schwab fund, it'll charge 0.69% to select shareholders.

An initial purchase of $500,000 or more will cost about a quarter of the investor's share class. At SFIVX, that'll drop expense ratios to 0.55% per year; at SFEMX, expense ratios for institutional share classes will wind up at 0.60%.

"This expansion of Schwab's lineup means all of the major equity asset classes people need in their portfolios can now be accessed using index mutual funds," Arnott said. "That's going to give investors a more complete alternative to market-cap-weighted investing."

The new pair will join three others launched in April 2007. Those are: Schwab Fundamental U.S. Large Company Index Fund (SFLVX); Schwab Fundamental U.S. Small-Mid Company Index Fund (SFSVX) and Schwab Fundamental International Large Company Index Fund (SFNVX). Similar PowerShares ETFs can be found for each and all sport lower expense ratios in their various share classes.

Research Affiliates just passed its three-year mark of offering fundamental indexing products. Some 70% of its $30 billion in assets are institutional-based, says David Hennessy, the firm's managing director.

And a majority of that uses some form of enhanced fundamental indexing methodology, he added. "We have partners in Australia, South Africa and Japan running our enhanced indexes. And I think we'll be launching a global enhanced index as we're seeing more demand for global products for the U.S. market," Hennessy said.

Schwab is evaluating those strategies and expects in the next several months to make a decision on possibly adding such enhanced fundamental indexed mutual funds to its family, says Bonardi.

"We expect to make some decision about which spaces would be the most appropriate for those types of funds in the next several months," he added.

Single country or sector funds aren't probably high on their lists, says Bonardi. "We want to keep it broader in terms of enhanced type of fundamental strategies. We want to smartly build out to complement the five fundamental index funds we'll have on the market by the end of this month," he said.

Individual investors own about 40% of the $820 million in assets Schwab's existing trio of fundamental index mutual funds have attracted, Bonardi estimates.

"That's what has taken us by surprise," he said. "We'd seen the demand for these types of products in the institutional market. But we were surprised by how many early adopters bought into these funds in retail markets."

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