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Charles Schwab Explains New Emphasis On Index Funds

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Active vs. passive management: Which is better?

In the traditional mutual-fund arena, this battle has raged for years.

Advocates of index investing argue that active managers can't outperform consistently enough. They also argue that higher costs are an additional anchor dragging down active fund returns.

The rising popularity of low-cost ETFs has added fuel to this fire.

Charles Schwab , the 76-year-old founder and chairman ofCharles Schwab ( SCHW ), and Anthony Davidow, 54, a vice president of the Schwab Center for Financial Research, recently emphasized the value of index investing in a white paper but held that there's still a place for actively managed funds.

IBD discussed the topic with them in separate conversations with Schwab in San Francisco and Davidow in Manhattan.

IBD: In a recent research paper, you noted that index funds can lose value faster in a downtrending market than actively managed funds, which can take evasive action. Is that why you advocate holding actively managed as well as index funds?

Schwab: Well, yes, in many respects. Many actively managed funds apply what we call asset-allocation modeling. They put assets into stocks, into fixed income, into cash, and try to moderate volatility of the stock market. They try to get good returns in up markets and mitigate bad returns in down markets.

Index funds by their nature are 100% invested in whatever their objective is.

IBD: Who should use only index funds? All shareholders?

Schwab: I'm trying to reach the 98% of people who aren't -- I hate to use this word -- sophisticated about investing or who aren't trained or schooled in investing.

There are about 320 million people in the U.S. Maybe 2% are reasonably sophisticated in investing.

That leaves about 314 million who don't read Investor's Business Daily or the Wall Street Journal. They can use index funds.

IBD: Is cost the key difference between actively managed and index funds?

Schwab: It's one of the key differences. Actively run funds are more expensive.

IBD: How should shareholders mix actively managed funds with index funds?

Davidow: We believe there's a role for active and passive strategies.

Part of the value of active managers is their ability to play defense. They have more ability to adjust a portfolio when there's a shock to the market.

Although we cite data that shows how difficult it is for active managers to persistently outperform -- and we're not the only ones making that point -- we believe there is a role for active managers.

And in fact, we would favor active managers who have a better downside protection capture ratio or better defensive measures in their portfolio.

Active and index -- each has strengths and weaknesses. We would advocate a combination.

We advocate a role for market-cap strategies in the traditional way that people bought index strategies in the old days.

Then we advocate a role for fundamental index strategies, which we refer to as "Indexing 2.0." That's the more involved view of how you get index exposure.

IBD: So you're not saying people should try to anticipate a downturn and then buy shares in a broad, actively managed fund?

Davidow: We're not recommending that investors allocate based on predicting the future.

We recommend that they have exposure to all three strategies. Based on individual preferences, they may choose to weight one more than the other.

IBD: How does "Indexing 2.0" differ from traditional market-capitalization indexing?

Davidow: "Indexing 1.0" was about providing cost-effective exposure to virtually every asset class.

Today, the typical investor who wants exposure to a broad segment of the market -- say the S&P 500 -- gets it in market-cap fashion. Each security in the basket is generally weighted by its market cap. A market-cap index multiplies the price of each individual stock by its number of shares outstanding. The largest companies have the largest weight in the index.

Recent innovations go beyond Indexing 1.0's link with share price. The innovations try to combine benefits of traditional indexing and active fund management.

One of those innovations is called fundamentally weighted indexing.

Schwab's fundamental indexing uses three factors: sales, cash flows and dividends plus buybacks. Others' fundamental strategies use different factors -- earnings, revenues and so on.

The rationale is that those fundamental factors may represent a company's true economic value more accurately than the size of a company, its market cap.

Fundamentally weighted indexes are sometimes referred to as smart beta because they seek to provide broad market exposure, known as beta, based on measures of a company's financial health.

IBD: Give me an example of how that makes a difference, please.

Davidow: In an S&P 500 market-cap index fund,Apple ( AAPL ) is the largest holding because it is the largest company. In the Russell Fundamental Large Index, which screens and weights based on economic factors, Apple is the 23rd largest holding. The difference in weighting methodologies could make a huge difference in fund performance.

IBD: How should a shareholder allocate among the three strategies?

Davidow: We would typically advocate having exposure to all three. Each has a role. The fundamental-weight strategy can lead to excess returns. But a customer who is more concerned with controlling costs may choose to favor a market-cap strategy.

If an investor is still smarting from the 2008 downturn, and he fears future market shocks, he may want a higher exposure to active managers, especially those with better downside capture ratios.

IBD: So market-cap index funds tend to have the lowest costs?

Schwab: That's right.

IBD: Your recent research paper points out that active funds still have far more in assets than index funds but that index strategies are gaining assets more rapidly. Do you foresee the demise of actively run funds?

Schwab: There is a huge trend of assets moving to index investing. But active funds will never disappear.

We all, including me, have ambition to do better than the average. But it's impossible to do it every year. We all fall to the mean of performance. So people are finding that index mutual funds or ETFs should be the core of their investing.

IBD: A cynic might wonder whether your company wants to see people switch to index funds because they're cheaper to run. Wouldn't that let the firm make more money?

Schwab: We as a company make something like 26 basis points per annum on assets we hold for clients. We hold $2 trillion.

Index funds make 4 basis points. We charge no commission going in, no commission going out. So we would make less with index funds.

But our pursuit is to have the best products that an individual can find so they can have a great investing career.

IBD: That's a lot of potentially sacrificed profit.

Schwab: In some ways, the pursuit of this (educational effort about indexing) is to lay out the benefits of indexing. It's a totally inconvenient truth for Wall Street. Indexing is low cost. Nobody makes much money unless you have huge scale and size. But it's a great product for the 98% of people who (should be) looking for the lowest-cost way of investing in America's great companies.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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