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Describing index investing as passive does a disservice to individual investors, says Charles Schwab, founder and chairman of The Charles Schwab Corporation, in his opening letter for a new report that helps individual investors better understand index investing and its role in wealth accumulation.
Authored by the Schwab Center for Financial Research,
The Wealth-Building Power of Equities and the Elegance of Indexing makes the case for index investing as a sophisticated time-tested means of capturing the growth potential of the economy.
A longtime believer in the power of index investing, which he calls a “most brilliant approach” in his letter, Mr. Schwab spearheaded the firm’s launch of the Schwab 1000 Index and mutual fund in 1991 to give investors a lower-cost diversified alternative to investing in individual stocks. “I believe indexing is unfairly perceived as unsophisticated,” he says. “Sometimes the most straightforward and simple approach is best.”
The report walks readers through the key features of indexing, from diversification, cost- and tax-efficiency to its disciplined, rules-based approach that enables better predictability of outcomes. Unlike actively managed funds, which have an individual manager who assesses and selects securities, index mutual funds and exchange-traded funds (ETFs) follow a stock or bond index, enabling them to own a basket of securities that change periodically based on specific, pre-established rules.
“I dislike the term passive because it implies lack of change,” says Schwab. “Index funds are dynamic and, by design, follow a rigorous methodology that alters their composition over time to reflect a changing economy.”
With Indexing at the Core, Active Management Can Bridge Gaps
The report illustrates how indexing, including traditional market-capitalization indexes as well as fundamentally weighted strategies, can form the core of an investor’s portfolio. Market capitalization indexes, which the report calls Indexing 1.0, rank companies based on the total market value of their stock, offering diversification and cost-effective exposure to virtually every segment of the market. With Indexing 2.0, or fundamentally weighted indexes, stocks are screened and weighted based on economic factors such as a company’s adjusted sales, cash flow, dividend history and share repurchase. These strategies capture many of the positive attributes of both traditional market-capitalization indexing and active management, and can add another layer of diversification.