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.
The report uses the Schwab 1000 Index® and other widely recognized benchmarks to distinguish market capitalization indexes from those that are fundamentally weighted, and to show how differences in construction, reconstitution and rebalancing can lead to very different results over time.The report points out that it is difficult for active managers to consistently outperform their benchmarks over the long-term, especially when factoring in fees. Data from the Schwab Center for Financial Research shows that only one actively managed equity mutual fund was able to rank in the top performance quartile for more than seven years between 2004 and 2013. But, the report emphasizes that active management can play the role of defense in a well-diversified portfolio, particularly since active managers have greater flexibility in responding to changing market conditions. The Schwab Center for Financial Research believes that there is value in taking the time to identify active managers who have exhibited better downside protection and can play defense during rough markets. What does this mean for investors? The Schwab Center for Financial Research believes that active management, traditional market-cap and fundamentally weighted strategies each have their own investment merits, and that they all deserve a place in a well-diversified portfolio, with indexing approaches appropriate for the core of many portfolios, both straightforward and sophisticated. The full white paper is available at schwab.com/indexing. About Charles Schwab At Charles Schwab we believe in the power of investing to help individuals create a better tomorrow. We have a history of challenging the status quo in our industry, innovating in ways that benefit investors and the advisors and employers who serve them, and championing our clients’ goals with passion and integrity. More information is available at www.aboutschwab.com. Follow us on Twitter, Facebook, YouTube, LinkedIn and our Schwab Talk blog. Disclosures Through its operating subsidiaries, The Charles Schwab Corporation (NYSE: SCHW) provides a full range of securities brokerage, banking, money management and financial advisory services to individual investors and independent investment advisors. Its broker-dealer subsidiary, Charles Schwab & Co., Inc. (member SIPC, www.sipc.org), and affiliates offer a complete range of investment services and products including an extensive selection of mutual funds; financial planning and investment advice; retirement plan and equity compensation plan services; compliance and trade monitoring solutions; referrals to independent fee-based investment advisors; and custodial, operational and trading support for independent, fee-based investment advisors through Schwab Advisor Services. Its banking subsidiary, Charles Schwab Bank (member FDIC and an Equal Housing Lender), provides banking and lending services and products. More information is available at www.schwab.com and www.aboutschwab.com. Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by visiting Schwab.com or calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Past performance is no guarantee of future results. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.The Schwab 1000 Index includes the stocks of the largest 1,000 publicly traded companies in the United States, with size determined by market capitalization (total market value of all shares outstanding). The index is designed to measure the performance of large- and mid-cap U.S. stocks. Indices are unmanaged, do not include fees and cannot be invested in directly. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (0514-3367)