Should I Invest in Schwab’s Fundamental Index Funds?

A reader writes in, asking:

“I currently use three Schwab ETFs for my portfolio: Schwab U.S. Broad Market, Schwab International Equity, and Schwab Short-Term U.S. Treasury. But I’ve been reading about their Fundamental Index Funds and ETFs as well. The idea of allocating to companies according to sales and cash flow makes a lot of sense to me. Do you think it would be prudent to add some of these funds to my existing holdings?”

As a bit of background information: Traditional index funds (and ETFs) are market-cap weighted. This means that each stock (or bond) held in the fund is held in proportion to its market capitalization (i.e., the total market value of the company). For example, if Verizon makes up 1% of the U.S. stock market, a market-cap weighted U.S. “total market” index fund would have 1% of its portfolio invested in Verizon.

In contrast, “fundamental” index funds (and now, in some cases, “smart beta” funds) weight companies according to their “fundamentals” (i.e., metrics such as sales, cash flow, or net income).

While I don’t think its typically useful to compare the performance of two funds in order to see which fund is better (remember, picking based on past performance is often worse than picking randomly), I do think it can be helpful to plot the performance of two funds on the same chart to see how similar they are.

For example, with these various new types of not-so-passive index funds, it’s often enlightening to:

• Look at where the fund falls in the tic-tac-toe-looking Morningstar style box (i.e., growth vs. value and small-cap vs. large-cap),
• Find a plain-old Vanguard fund with a comparable position in the style box, and
• Plot the two funds together on the same growth chart.

With regard to the reader’s question, let’s run through the above exercise with three Schwab Fundamental Index Funds.

Our first chart shows the Schwab Fundamental US Large Company Index Fund (SFLNX, in blue) and the Vanguard Large-Cap Index Fund (VLCAX, in orange), since the inception of the Schwab fund:

The following chart shows the Schwab Fundamental US Small Company Index Fund (SFSNX, in blue) and the Vanguard Small-Cap Index Fund (VSMAX, in orange), since the inception of the Schwab fund:

And the final chart shows the Schwab Fundamental International Large Company Index Fund (SFNNX, in blue) and the Vanguard International Value Fund (VTRIX, in orange), since the inception of the Schwab fund:

You can see periods in each of these charts in which one fund outperforms the other, but the overwhelming takeaway that I see is simply how very similar the funds are.

And that’s typically how it goes when I look at a fund in one of these newer categories. They’re usually perfectly fine funds. (After all, going toe-to-toe with a low-cost index fund from the most respected provider of index funds is nothing to laugh at!) But there’s usually little substance behind the marketing message that these are a distinct improvement over traditional index funds. For the most part, they’re simply a new way of arriving at the same old portfolio (or very close to it).