CLRG - FNDX: There Are Better Smart-Beta ETFs Out There

2023-08-03 18:01:50 ET

Summary

• FNDX appears to be an alternative to broad-market index funds by using a unique methodology in selecting and weighting stocks.
• While this could be useful for some traders, it's not ideal for long-term investors.
• In this article, I will explain why this is so and what better alternatives exist for long-term holders.

Thesis

Schwab Fundamental U.S. Large Company Index ETF (NYSEARCA: FNDX ) is an equity ETF that offers a different weighting structure than broad-market index funds due to its unique methodology in the stock selection process. While its approach can seem sound in theory, it's difficult to identify any benefit in practice for long-term investing in my view.

There is a chance FNDX may be the kind of fund traders are going to use in certain market periods in anticipation of market changes that are going to be most favorable to a fund with these kinds of allocations. But I am not a trader and I cannot assess this. After some research, I found out that there are better long-term bets when it comes to smart-beta equity exposure. And this is what this post is all about.

What does FNDX do?

FNDX was launched and managed by Charles Schwab Investment Management, Inc. on 08/15/2013. It currently manages about $12 billion and charges a 0.25% expense ratio.

Its goal is to track the Russell RAFI US Large Company Index, which scores and selects stocks based on fundamental factors that define company size, namely adjusted sales, retained operating cash flow, and dividends plus buybacks. That certainly sets it apart from other smart-beta indices that use market capitalization to define company size.

Definition of the fundamental factors:

• Adjusted sales as the 5-year average revenue figures multiplied by a leverage adjustment factor which is the average equity to average assets.
• Retained operating cash flow as the 5-year average operating cash flow minus dividends/buybacks.
• Dividends plus buybacks as the 5-year average dividends paid and share buybacks.

The index uses the FTSE Global Total Cap Index as its available universe. First, it ranks the stocks by using the average of the three values taken from the above factors to determine the aggregate fundamental value of each constituent. Then, the companies that rank above the 87.5 percentile based on their values are classified as large and are included and weighted accordingly in the index.

What really stands out with this particular smart-beta ETF is its current allocations. It has about 18% invested in tech and 17% in financial stocks. SPY has about 29% in technology and only about 12% in financials.

When it comes to its top 10 holdings, they greatly overlap those of SPY but the weights look very different. For instance, FNDX has 4.66% invested in Apple Inc ( AAPL ) and 2.22% in Berkshire Hathaway Inc Class B ( BRK.B ). SPY has 7.53% in AAPL and only 1.62% in BRK.B. You get the idea.

Performance

First of all, FNDX has realized annualized returns of 11.51% in the last 5 years while its benchmark marked returns of 11.78%. While we can note an efficiency in its tracking so far, one has to think about the use of this smart-beta fund; the Russell 1000 Index marked an 11.92% return per year in the same period. We can also see how FNDX underperformed SPY since it launched:

And when it comes to its risk profile, no advantage has been noted over 10 years of performance, except for a much milder worst year than what an investment in SPY would experience. I guess that this different exposure structure is to some degree efficient in hedging the risk that comes with tech stocks.

Is this something that is worth the opportunity cost illustrated above by the performance difference? Well, I can understand that for some investors this might be the case. But because I don't value this as much as performance, no points have been scored so far for those interested in long-term equity investing.

But let's explore some alternatives and see how other smart-beta ETFs have performed. Just keep in mind that the ones below do not operate based on a redefinition of "company size" (that is kind of unique as far as I know). However, they're the best candidates for comparison as opposed to the ubiquitous smart-beta funds focused on growth, value, momentum, yield, etc.

As you can see, FNDX has outperformed its peers in the last ~5 years. It's safe to say that if an investor were looking for the best performance from a fund with no strong growth, value, or other factor bias, FNDX would be a good choice. Since all of these options have realized similar risk profiles, FNDX looks good on a risk-adjusted basis too.

Source : portfoliovisualizer.com (Jan 2018 - Jul 2023)

At the end of the day, when it comes to smart-beta equity exposure, growth looks to be the better option during bull markets. The iShares Russell 1000 Growth ETF ( IWF ) significantly outperformed both SPY and FNDX in the last ~10 years.

Now, does IWF come with a much less attractive risk profile? Not really.

Source : portfoliovisualizer.com (Sep 2013 - Jul 2023)

Another interesting smart-beta ETF is the Invesco S&P 500 Equal Weight ETF ( RSP ). As the name implies, it uses an equal-weighting approach to equity exposure. That seems to have worked quite well for a long time.

No doubt, some traders may derive some kind of value from FNDX during certain market periods that I and so many long-term investors couldn't. But setting this exception aside, I can't find any reason to invest in FNDX.

Risks

• Market Risk : FNDX is exposed to market risk just like any broad-market ETF. Its value is tied to the performance of the market as a whole and is indirectly affected by political, economic, and regulatory changes, among others.
• Equity Risk : The ETF invests in equities for the most part and that makes it subject to the risk that comes with investing in securities issued by publicly traded corporations.
• Concentration Risk : Since the fund tracks an index that can become concentrated in a specific industry or sector, it can also become concentrated as well at some point.

For the full list of risks, examine the fund's prospectus .

Verdict

FNDX is definitely a cheap smart-beta equity ETF with a unique methodology and an obvious advantage over market-cap-biased ETFs for those looking to minimize exposure to technology.

That being said, I can't find any reason to hold this instead of a more traditional broad-market index fund. If you want the benefits of a different weighting structure than SPY and similar funds, as well as superior performance, ETFs like IWF and RSP appear to be a better bet.

What's your take? Leave a comment below and let's have a discussion. And as always, thank you for reading.

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