Fundamental differences over Schwab funds

SAN FRANCISCO — Charles R. Schwab last week called the fundamental indexes underlying his company’s three newest mutual funds “a better mousetrap,” but The Vanguard Group Inc. and Barclays Global Investors smell a rat. The two companies presented a united front in saying that the chairman and chief executive of San Francisco-based Charles Schwab Corp. and the company’s new partner, Research Affiliates LLC of Pasadena, Calif., shouldn’t label their new funds “indexes,” which they said implies passive investing. Schwab and Research Affiliates launched the funds last Monday, and Mr. Schwab made his comments during a teleconference that day. “In our view, the fundamental approach is not indexing,” said Vanguard spokesman John Demming, who noted that George U. “Gus” Sauter, the Malvern, Pa.-based company’s chief investment officer, was out of town or he would have addressed the issue. Having it both ways? Both Vanguard and San Francisco-based Barclays contended that the new offerings — the Schwab Fundamental US Large Company Index Fund, the Schwab Fundamental US Small Company Index Fund and the Schwab Fundamental International Large Company Index Fund — are being touted as market beaters, which means that an active process is at work. Schwab and Research Affiliates want to have their cake and eat it, too, said Michael Latham, managing director and head of Barclays iShares for North America. “What bothers us is that it’s on sale as an index,” he added. “We absolutely disagree with that.”
But this disdain is a narrow view based on yesteryear’s thinking about indexing, according to Robert Arnott, chairman of Research Affiliates. “In the Oxford dictionary under ‘index,’ I don’t see cap weighting there,” he said. The composition of traditional indexes is determined by the size of a company as measured by its market capitalization. Under Mr. Arnott’s formula, indexes are determined by a company’s fundamentals, including its earnings and its balance sheet. Vanguard and Barclays are unlikely to endorse his brand of fundamental indexing because of the threat it poses to them, according to Jeffrey Zlot, managing director and co-founder of Presidio Wealth Management LLC of San Francisco. “The big players certainly see this as a threat, so they want to paint it as not [being] an index,” he said. But Vanguard executives — with the backing of many respected academics — take a dim view of fundamental indexing. Burton Malkiel, the Princeton (N.J.) University professor of finance known as the father of the efficient-markets theory, blasted fundamental indexing in a debate with Mr. Arnott at a meeting of the Investment Management Consultants Association held here Feb. 26. Some take issue with that viewpoint. Investors should view indexing agnostically, said Herb Blank, founding principal of QED International Associates Inc., a quantitative-consulting firm based in New York. “I have tremendous respect for Barclays, but this is investments and not religion,” he said. “They’re treating these guys like heretics.” And Mr. Arnott shows good faith, Mr. Blank said. “An index fund is any investment that follows a systematic methodology that governs an index,” and by that definition, “fundamental indexing” is as good as any other form of it, he said. Barclays disagrees. ‘Bear market trap’ The company, in fact, a few years ago took a pass on using Mr. Arnott’s methodology for its own exchange traded funds, Mr. Latham said. “We just think it’s rudimentary,” he said. Under Research Associates’ system, Mr. Latham added, “there’s a lack of transparency about how the final bucket gets created.” He said Barclays plans to introduce a product that would make clear for investors why certain stocks get selected and would draw on more fundamental inputs. When Barclays releases ETFs designed to beat the market averages, it will release actively managed ETFs in stages, Mr. Latham said. The first ones will be funds of funds that allocate among asset classes. ETFs comprising individual securities eventually will follow, Mr, Latham said. No actively managed ETFs ever have been approved by the Securities and Exchange Commission, though there are some in registration with the commission. But for advisers who want an alternative form of passive investing now, Mr. Arnott’s version of fundamental investing looks great. “We think cap-weighted indexes lead to a bear market trap,” based on how the Standard & Poor’s 500 stock index crashed during the technology implosion of 2001, Mr. Zlot said. He began using Mr. Arnott’s approach a year ago through the ETFs of PowerShares Capital Management LLC of Wheaton, Ill. The embrace by financial advisers of fundamental indexing — as shown by the billions of dollars that are flowing into PowerShares’ ETFs — is the ultimate endorsement, according to Mr. Arnott. “This is an idea that has gained massive traction with what are usually the late adopters,” he said. “Usually, financial advisers want a long track record,” which his own products don’t have, Mr. Arnott said. Mr. Zlot said he is impressed that Mr. Arnott’s methodology produced positive returns in back-testing, while the Russell 3000 Index had losses of more than 10% in 2000 and 2001. The cap-weighted methodology broke down by herding investors into tech stocks, which dominated the indexes at that time, he noted.