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Fundamental Indexing Poised to Outperform in Sixth Year of Bull Market Says New Charles Schwab Whitepaper

SCHW | July 21, 2015

A new report released by the Schwab Center for Financial Research, a division of Charles Schwab & Co., Inc., finds that fundamental indexing, a Strategic Beta strategy¹, may be poised to outperform market-cap strategies as the secular bull market enters the mature phase. The paper explains that as the market matures, it becomes more important for investors to focus on holding strong companies with sound fundamentals.

“Why Fundamentals—Why Now?” is the latest whitepaper from Anthony B. Davidow, alternative beta and asset allocation strategist with the Schwab Center for Financial Research. In the whitepaper, Davidow reasons that the current market is likely to reward fundamental indexing because of the screening and weighting methodology, which looks at the economic factors of underlying companies rather than overweighting the most popular stocks.

“In the early stages of a bull market, merely being exposed to the market through market-cap weighted strategies should lead to portfolio growth,” says Davidow. “But, as we enter the sixth year of the bull market, fundamentals should matter.”

While some will argue that stock prices are expensive, Davidow argues that the market can still include individual securities that are inexpensive or fairly priced. “Using a rules-based process, fundamental indexing sells the companies that have appreciated the most and buys companies that have been out of favor. The beauty of this disciplined rebalancing approach is that it removes the emotion that often hinders investors from making the most logical investment decisions.”

Why Fundamentals, and Why Now?

In traditional market-cap indexes, companies with the largest market capitalization typically hold the largest positions. Fundamentally weighted indexes break the link with stock price in determining company weightings. Instead, securities are selected and weighted by objective financial measures such as adjusted sales, cash flow and dividends + buybacks.

As a result of their different underlying constructions, market-cap and fundamental indexes tend to perform differently depending on market conditions. Market-cap indexes have a larger-cap bias, and will experience momentum over time – particularly in “boom” periods like the late 1990s, or periods of extended momentum where valuations become elevated. Fundamental indexes tend to have a value-tilt. They are not value indexes, but because of the factors used in screening securities they will have more value characteristics than the market.

Davidow’s research shows that traditional market-cap, active and fundamental index strategies are complementary, and provide investors with an additional layer of diversification that strive to span all points within a market cycle. For those investors who only hold traditional market-cap index strategies, Davidow says that it may be an opportune time to consider adding one or more fundamentally weighted strategies to their portfolios.

The full whitepaper, part of Schwab’s Investing Ideas series, is available here.

Schwab Investing Ideas offer analyses of key market trends and investing opportunities investors can act on now from the Schwab Center for Financial Research. More information, including other recently published insights, can be found on Schwab’s Investing Ideas page.

Visit here to view additional research from Davidow on the benefits of Fundamental Indexing strategies.

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Disclosures:

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data.

The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Through its operating subsidiaries, The Charles Schwab Corporation (NYSE:SCHW) provides a full range of securities brokerage, banking, money management and financial advisory services to individual investors and independent investment advisors. Its broker-dealer subsidiary, Charles Schwab & Co., Inc. (member SIPC, www.sipc.org), and affiliates offer a complete range of investment services and products including an extensive selection of mutual funds; financial planning and investment advice; retirement plan and equity compensation plan services; compliance and trade monitoring solutions; referrals to independent fee-based investment advisors; and custodial, operational and trading support for independent, fee-based investment advisors through Schwab Advisor Services. Its banking subsidiary, Charles Schwab Bank (member FDIC and an Equal Housing Lender), provides banking and lending services and products. More information is available at www.schwab.com and www.aboutschwab.com.

¹ Morningstar defines strategic beta as a class of investment products that track indexes that seek to either improve performance or alter the level of risk relative to a standard benchmark.

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