Fundamental indexing in today’s market
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JENNA DAGENHART: Joining us now to share what’s top of mind for financial advisors and discuss fundamental indexing in today’s market environment, we have DJ Tierney, Senior Investment Portfolio Strategist at Charles Schwab Investment Advisory, and Brent Leadbetter, partner at Research Affiliates. Well, Brent, DJ, great to have you both with us.
And, Brent, kicking us off here, what are some concerns you hear from advisors about risks in the market?
BRENT LEADBETTER: Sure. Well, thanks for having us, Jenna. And, yeah, your first question regarding concerns that we’re hearing, I think concentration comes up first and foremost. Advisors are concerned about the heavy concentration in the market today. Just as an example, if you look at a six tech or tech-related companies in the US, the FAANG stocks plus Microsoft and Apple, the FAANG stocks being Facebook, Amazon, Netflix, and Google/Alphabet, those six companies alone finished 2020 with a combined market cap of $8 trillion. Just to put that in perspective… that sounds like a big number, because it is a big number. To put that in perspective, if they were their own country, they would be the third largest country in the world. Further, their combined market capitalization exceeds that of all the publicly-listed equities in any three European countries combined. Put simply they’re very expensive, right? And so this concentration has been a big concern of investors who are using cap-weighted indices, that they have a lot of their money piled into a small handful of companies.
JENNA: Yeah, that’s a lot of market cap. After concentration risks, are there any other concerns?
BRENT: The second concern that comes up that’s really closely related to concentration is valuation, right? Investors are concerned about the dispersion between value and growth that has resulted, in large part, due to this market concentration. We track the valuation of value, and we look at… what we look at over time is how cheap is value relative to growth. By definition, value is always going to be cheaper than growth, that’s how you build the portfolios, but the degree to which value is cheaper than growth varies, and it varies pretty considerably over time. We prefer a definition that uses multiple metrics. We don’t look solely at price-to-book value alone. We actually wrote a paper last year where we compared using price-to-book alone to value companies, to valuing a home solely on price-to-bedroom ratio. Right? It’s an incomplete measure. So we use multiple metrics. We use price-to-book, sales, cashflow, dividends, and earnings. Using those five measures, on average, globally, value generally trades at around 30% the price of growth. Today, it’s quite a bit cheaper. At the bottom in 2000, value got to be only 12% the price of growth in the US, 13% in emerging markets, and only 17% in developed ex-US markets. Globally, in all three major regions, value was trading well below its historical median valuation relative to growth.
JENNA: Now, Brent, with market performance this year we’ve heard that value has staged a comeback. Have the valuations changed to make the value factor less attractive?
BRENT: There’s been some change, in that value had a strong rebound. From the beginning of September through the end of… from the beginning of September 2020 through the end of March 2021, the Russell 1000 value beat the Russell 1000 growth by almost 19 percentage points. So it’s a pretty strong rebound, but that’s only seven months of excess return. And, frankly, seven months of rebound does not undo 14 years of underperformance. The gap between value and growth remains quite wide. Those six companies that I mentioned earlier, the FANMAG, to use our clunky acronym, those companies that ended 2020 at nearly $8 trillion in combined market cap, by the end of July 2021, they had grown further to more than $9 trillion in market cap.
So market concentration remains a problem, valuation dispersion remains very wide, there remains a very big gap between growth and value. To go back to those metrics I referenced earlier, value is trading at about 15% the price of growth in both the US and emerging markets, and about 20% the price of growth in developed international markets.
So value is literally half as expensive as it normally is in the US and in emerging markets, and it’s roughly a third off in developed international markets, or put simply, value is on sale globally.
JENNA: Market news cycles have been busy this year, and it’s not just the valuations making headlines. DJ, turning to you, what’s been noteworthy from your perspective and what does this mean for positioning client portfolios?
DJ TIERNEY: Yeah, thanks, Jenna. Yeah, 2021 has not disappointed on the news front. There’s been so much for investors to consider. And we really need to start the conversation with the COVID-19 pandemic. We began the year with a lot of positive news around the effect of the vaccine, and the reopening of the economy, you know, very positive GDP numbers coming together in the first half. And that even led to the rise of prices and the discussion of inflation, what could the Federal Reserve’s policy response might be. Now, more recently, we’ve had the Delta variant and increasing cases maybe questioning that recovery. So lots for investors to consider. We even have investors making the news, themselves, this year, with large numbers of new investors entering the market for the first time, some motivated around social media even. And, with that, record inflows into ETFs as a whole.
So one thing we like to remind investors, especially newer investors with this news cycle and all the unpredictability, is ignore the noise. We never know what the future is going to bring. So sticking to what you can control, which is a diversified long-term plan, is something that you can focus on and control, and something we really want to emphasize for newer investors.
JENNA: Regarding all the new ETF launches and the new actively managed semi-transparent ETF structure, what does this mean for existing ETFs like Schwab Fundamental ETFs?
DJ: Yeah, it’s been a busy year for new ETF launches. Year-to-date, over 200 new ETFs have come to market, and, interestingly, over half of those are actively managed which is a departure from the existing ETF landscape. And of the actively managed, 13 are this new vehicle, semi-transparent, actively managed ETFs.
So, in aggregate, you know, more choices. Good for investors. Competitive landscape has been a positive thing for investors. It does make the selection process a little bit more complicated. More choices, more things to consider. So one of the things we like to point out with ETFs like Schwab Fundamental Index ETFs, are you can take some comfort from their time in the market. This suite of ETFs was launched in August of 2013, so we’re coming up on eight years of these ETFs with time in the market. So you can look at demonstrated market returns. You can see how they’ve behaved over different time periods, which can be useful for advisors and investors evaluating them.
JENNA: If advisors want to invest in Fundamental Index ETFs, DJ, what’s an approach to implement them in a portfolio?
DJ: What you’ll see with a lot of Schwab advised solutions where we put together portfolios, is that you’ll see Schwab Fundamental Index ETFs alongside Schwab traditionally indexed ETFs. And we find them, together, we even use the term ‘better together,’ can be a really logical way to assemble a portfolio. And some of this is based on the unpredictability of the future. You know, we don’t know what’s coming around the corner. So if you have strategies that will perform differently in different market environments, and then you rebalance those strategies over time, it can lead to a smoother ride and potentially better long-term risk-adjusted returns for those portfolios. So we think taking fundamental index strategies and partnering them alongside traditional index strategies can be a good way to go.
JENNA: Finally, why is fundamental indexing relevant in today’s market environment?
DJ: Well, Jenna, we think it is. For all the things we’ve discussed so far about the 2021 market environment and the resurgence of value performing well, particularly in the first quarter, we think it is. And, also, just going back to having a long-term plan, not overreacting to current market conditions, but sticking to a pragmatic long-term plan we think makes a lot of sense.
But why don’t I turn it over to Brent to see if he wants to make some specific points about fundamental in 2021.
BRENT: Yeah. I would just remind everyone that our RAFI Fundamental Index strategies, at their core, are designed to be contrarian, right? Instead of weighting companies by price, we’re weighting by fundamental measures of size, specifically, sales, cashflow, and dividends. This has given us an inherently contrarian position. It’s also ensuring that we’re offering diversification, and, importantly, we’re offering diversification away from the market precisely when the market has become most concentrated. We’re also going to be offering a value tilt, and that value exposure is widening as the gap between growth and value becomes biased, right? You would have wanted non-price exposure when the Nikkei was peaking in ‘89. You would have wanted non-price exposure when technology was… when the NASDAQ was peaking in 2000. You would have wanted non-price exposure when value companies were getting very cheap during the financial crisis. Again, in 2015, after the ruble had collapsed, you wanted non-price exposure. You wanted to weight by a measure other than market cap in emerging markets. And, today, given the just historical gap that we see in dispersion between value and growth companies, we think that diversification makes a lot of sense, and weighting by a measure other than price, such as the RAFI strategies do, is a great way to get that diversification.
JENNA: DJ, Brent, thank you very much for joining us.
DJ: Thank you, Jenna. Thanks for having us.
BRENT: Thanks, Jenna.
JENNA: And thank you for watching. Once again, that was DJ Tierney, Senior Investment Portfolio Strategist at Charles Schwab Investment Advisory, and Brent Leadbetter partner at Research Affiliates. I’m Jenna Dagenhart with Asset TV.
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D.J. Tierney, Senior Investment Portfolio Strategist, Charles Schwab Investment Advisory, Inc., and Brent Leadbetter, CFA®, Partner, Research Affiliates, discuss fundamental indexing in today’s market environment and address some of the primary concerns advisors have around risks in the market.