Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA, and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Friday, March 1, 2024. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Index Funds As Businesses — Fundamental Indexing

We extend our newsletter series on stock index fund investment as a ‘conglomerate’ business. Thus far, we have authored newsletters covering a spectrum of concepts, ranging from perceiving the S&P index as a robust ‘conglomerate’ to identifying S&P ‘good’ sectors and exploring ‘good’ industry ETFs/Fidelity Select mutual funds as viable business entities:

We firmly advocate adopting the mindset of a business investor, or a business ‘fractional’ owner, when engaging in stock index fund investments. By aligning their investment horizon and attention to the fundamental metrics of the underlying businesses, investors can transcend the conventional view of a fund as merely a collection of stocks. Similar to acclaimed business investors like Warren Buffett, there is considerable reassurance in investing in a collective of businesses that, in the aggregate, form a robust business entity, regardless of how their prices behave during specific market extremes. Just like what Buffett said, you can have a sound sleep at night if you know the businesses you invest in are solid and sound. 

In this newsletter, we are introducing fundamental indexing funds. We believe the methodology of these indexes closely aligns with our business index fund investment concept. Fundamental index funds provide another avenue for us to exercise this business-oriented investing approach.

Fundamental Indexing: A Natural Approach for Business Index Fund Investors

As an investor in a ‘conglomerate’ index fund business, the critical and distinguishing factor lies in capital allocation. This principle echoes Berkshire Hathaway’s Buffett, who emphasizes that Berkshire’s competitive advantage lies in the strategic allocation of capital among its subsidiaries.

The concept of ‘fundamental indexing’ was introduced around 2005 by Robert Arnott and others at Research Affiliates. Renowned for its mutual fund and ETF products in collaboration with PIMCO and Schwab, Research Affiliates has left an indelible mark. The following ETFs and mutual funds are based on the RAFI (RA Fundamental Index): [Insert ETFs and Mutual Funds here]

The core principle of a fundamental index diverges from that of a traditional index, such as the S&P 500 or Vanguard Total Stock Market Index in the way that the latter relies on market capitalization (where the weights of underlying stocks are determined by their market capitalization) and a fundamental index bases its weights on four essential business metrics. Importantly, these metrics are considered irrespective of whether the stocks have high or low market capitalizations (stock prices).

The four fundamental business metrics are as follows:

  • Sales or revenues: the average of company sales over the past five years
  • Cash flow: the average of the company’s operating income plus depreciation & amortization over the past five years
  • Book value: company book value
  • Dividend: total dividend distributions averaged over the last five years, including both special and regular dividends paid in cash.

For each of these four metrics, companies’s values are normalized in this category (referred to as normalized value). The index subsequently combines these four normalized values with equal weights to establish a final fundamental value for each company. Weights are then derived based on the fundamental values of the companies. It’s crucial to note that these weights bear no connection to the current stock prices or market capitalization of the companies; instead, they are exclusively based on business fundamentals.

Several essential points warrant attention:

  1. If a company does not distribute dividends, its fundamental value would be determined as the average of the normalized values for the other three metrics: Sales, cash flow, and book values.
  2. If a company experiences negative cash flow, it would contribute negatively to its overall fundamental value. This is intended. 
  3. Conversely, if a company has substantial sales, it will positively contribute to its final fundamental value and, consequently, its weight in the index.

Business momentum vs. price momentum

A traditional market capitalization index, such as the S&P 500, incorporates price momentum into its index construction. Specifically, when a company’s stock price experiences rapid growth, its market capitalization increases correspondingly, resulting in an augmented weight in the index. This phenomenon is exemplified by the ‘magnificent seven’ stock scenario in the S&P 500, where the cumulative weight of Microsoft, Apple, Nvidia, Amazon, Google (Alphabet), Meta, and Tesla accounted for 28% of the S&P 500 index by the end of 2023 due to their significant price increases.

Conversely, a fundamental index embeds business momentum. If a company achieves substantial sales growth or possesses a significant book value, it acquires greater weight. It’s important to note that fundamental indexing factors in dividends and places emphasis on a more steadfast book value in its weight calculation. Thus it is not solely reliant on business momentum.

The following comparison looks at the top 10 holdings for the Schwab US Large Company Fundamental Index ETF (FNDX) and the S&P 500 index fund.

Currently, the high-flying AI stock Nvidia (NVDA) holds a weight of 0.41% in FNDX, ranking 57th in the index. In contrast, it commands a weight of 5.28%, placed at the top 3rd position in SPY. It’s noteworthy that Nvidia’s weight in FNDX could have been even lower if not for its recent rapid sales growth.

It’s important to observe that a fundamental index fund is typically categorized as a value index fund (both Research Affiliate and Morningstar classify FNDX as large value). However, unlike a traditional value index, which would likely underweight or potentially delist Nvidia as it becomes more expensive based on metrics like price/earnings or price/sales, it still maintains a substantial weight in the final fundamental index. On the other hand, it won’t carry as much weight as in a traditional large blend or large growth index fund. A fundamental index fund falls between a value and growth fund, albeit with a slightly more value-oriented tilt compared to a blend fund.

Fundamental indexing adopts a perspective akin to that of a business operator. If one were in charge of the 1000 largest US companies as the head of this ‘conglomerate’, the capital allocation (weights) would likely be based on each subsidiary’s business performance, such as sales and cash flow, rather than solely relying on stock market prices for capital allocation or weights in the index.

However, it’s crucial to note that fundamental indexing is not entirely business operation-oriented. The book value and dividend components lean more towards business value. It remains intriguing to observe whether there will be further modifications or variations in ‘fundamental’ indexing in the future.

Performance, cost, and tax efficiency

Let’s begin by examining the returns of Schwab’s fundamental index mutual funds, given their more extended history compared to their ETF counterparts. The positive aspect is that ETFs can be virtually purchased in any brokerage, unlike mutual funds, which may not be available in certain brokerages. For instance, Schwab’s mutual funds are not available as No Transaction Fee (NTF) funds in Fidelity. However, you can purchase Schwab ETFs, such as FNDX, commission-free in Fidelity.

Comparing the returns of fundamental index funds to traditional index funds (as of 3/8/2024):

Fund YTD
1Yr AR 3Yr AR 5Yr AR 10Yr AR 15Yr AR
SFLNX (Schwab Fdmtl US Lg Co Idx) 5.4% 26.1% 12.4% 15.4% 11.7% 17.5%
VFINX (Vanguard 500 Index Investor) 7.7% 31.3% 12.1% 15.2% 12.6% 16.5%
SFSNX (Schwab Fdmtl US Sm Mid Co Idx) 1.0% 13.2% 5.0% 10.5% 8.4% 16.6%
IWM (iShares Russell 2000) 3.0% 12.9% -0.5% 7.9% 7.1% 14.1%
SFNNX (Schwab Fdmtl Intl Lg Co Idx) 3.5% 19.9% 7.8% 9.2% 5.3% 10.3%
VEA (Vanguard FTSE Developed Markets ETF) 4.3% 17.6% 4.8% 7.9% 5.0% 9.6%
SFENX (Schwab Fundamental Emerg Mkts Idx) 1.5% 17.3% 3.9% 5.3% 4.6% 8.1%
VWO (Vanguard FTSE Emerging Markets ETF) 1.6% 7.7% -3.4% 3.5% 3.7% 7.8%

A few notes:

  1. With the exception of US stocks, where the fundamental index fund SFLNX lagged behind VFINX over the past 15 years, all other fundamental index funds surpassed their traditional index fund counterparts. Notably, the US small-cap stock funds exhibited the most significant outperformance, exceeding 2% annually over the past 15 years.
  2. The notable outperformance observed in the categories of US small-cap, foreign large-cap, and emerging market stocks is indeed remarkable, spanning across various timeframes, including the past 1, 3, 5, 10, and 15 years.
  3. The underperformance observed in the US large-cap category can be largely attributed to the dominating performance of specific large-cap US stocks, such as the recent ‘magnificent 7’ or the previous FAANG stocks, over the past 15 years. Notably, the S&P 500 index fund SPY is currently classified as a growth fund by Morningstar, moving away from its previous classification as a large blend fund. As the AI frenzy subsides and US stocks stabilize or undergo a bear market, we believe there is a high possibility that the fundamental index fund will eventually show outperformance.

The following table compares expense ratios: 

Fundamental funds generally carry slightly higher expense ratios, and this could potentially impact investors’ returns negatively.

Regarding tax efficiency, fundamental index funds tend to incur a slightly higher frequency of rebalancing activities compared to market capitalization-based traditional index funds. Market cap-based funds are inherently natural and necessitate fewer adjustments in terms of weights, as market capitalization values inherently regulate weights. However, we believe that the difference is not significant enough to undermine the merits of fundamental index funds.

In conclusion, fundamental index funds have demonstrated a long history of outstanding performance. Their alignment with a business investor’s approach to investing makes them valuable additions to portfolios. We believe that investors can consider incorporating fundamental index funds into their investment portfolio.

Market Overview

As of the end of last month, as reported by Factset, the S&P 500 demonstrated a blended 4% earnings growth for Q4 2023, surpassing the earlier anticipated 1.6% growth rate projected on December 31, 2023. This positive performance is encouraging.

Economically, the unemployment rate had increased to 3.9% last month. Additionally, retail sales exhibited a year-over-year decline, indicating some underlying sluggishness in the economy.

Despite these economic indicators, stocks have recently reached all-time highs.

As always, we claim no crystal ball and we call for staying the course which is guided by the well defined and sound strategic and tactical strategies:

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as we have emphasized numerous times when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years, preferably much longer, given the current high valuation. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later and preferably many more years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially during this time. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This is true time and time again.

Stock valuation has dropped, and now valuation is becoming less hostile. However, it is still not cheap by historical standards. For the moment, we believe it’s prudent to be extra cautious. However, how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of market is through dollar cost average (DCA), i.e., invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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