Schwab Says Index Investing Gets Short Shrift

Schwab is so passionate about the value of index investing that the Schwab Center for Financial Research released “The Wealth-Building Power of Equities and the Elegance of Indexing,” a report to help investors better understand index investing and its role in wealth accumulation.

The reputation of Index funds as static is false, Schwab says. A number of the stocks in the Schwab 1000 change annually. The fund may not be as dynamic as a managed account, he says, but it is active and he would stack the outcomes against those of managed funds, especially when the reasonable costs are factored in.

Schwab says the time for this report is critical, given growing concern about the inadequacy of retirement savings. “Not enough people are participating in the market, but it is the cheapest, easiest way for Americans to build a portfolio and build personal wealth,” he says.

Schwab feels the media has been unfair to index investing, and has ignored its cost efficiency, cheap diversification and the emotional safety net that is so important to people. “It’s a cheap way to get into the market,” he says.

The only asset that truly grows is company stock, Schwab says. Of course not every company experiences growth, but he says that every board he’s ever served on—some six or seven S&P 500 companies—always discussed growth. If the management is not actually growing the firm, it is generally replaced. “It doesn’t happen in any other vehicle,” he says. Not land, agriculture or real estate.

Using real estate as an example, Schwab points out a 100,000-square-foot building will always be precisely that. He called corporations “the greatest thing in the world,” and said that inviting people to participate in the growth of companies is a low-cost way for average people to build personal wealth.

A longtime believer in the power of index investing, which he calls a “most brilliant approach” in his letter, 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.”

Indexing the Advantages

The report outlines the key features of indexing, from diversification, cost- and tax-efficiency to its disciplined, rules-based approach that enables better predictability of outcomes. While actively managed funds have an individual manager who assesses and selects securities, index mutual funds and exchange-traded funds (ETFs) follow a stock or bond index. This enables them to own a basket of securities that change periodically based on specific, pre-established rules.

Indexing, including traditional market-capitalization indexes as well as fundamentally weighted strategies, can form the core of an investor’s portfolio, the report contends. 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.

 It is difficult for active managers to consistently outperform their benchmarks over the long-term, especially when factoring in fees, the report contends. Between 2004 and 2013, just one actively managed equity mutual fund was able to rank in the top performance quartile for more than seven years, according to data from the Schwab Center for Financial Research.

Index funds are an incredibly low-cost way for someone to buy into 1,000 companies for $1,000, Schwab says. The cost is just $3 a year for oversight—an efficient way for the average American to buy into the growth of companies.

The full white paper is available at schwab.com/indexing.