This strategy attempts to profit from mean-reversion in valuations.

by Alex Bryan
Schwab Fundamental U.S. Small Company ETF FNDA

Schwab Fundamental U.S. Small Company ETF FNDA applies a disciplined contrarian rebalancing approach that should give it an edge over the long term. While there is much to like about this strategy, its weighting approach may cause it to overweight stocks with deteriorating fundamentals, and it charges more than market-cap-weighted value alternatives. It earns a Morningstar Analyst Rating of Bronze.

This is a value strategy, though it doesn't explicitly target value stocks. Instead, it offers broad exposure to small-cap U.S. stocks, with some mid-caps in the mix, and weights them on fundamental measures of size, including sales (adjusted for leverage), retained operating cash flow, and dividends plus share buybacks. This approach pulls the portfolio toward stocks trading at low multiples of these metrics, but it often does not have a noticeable value tilt.

Fundamental weighting helps the fund buy low and sell high. To rebalance to its target weightings, the fund must increase exposure to stocks that have become cheaper relative to their peers and trim positions in those that have become more expensive. These disciplined bets against the market should give the fund an edge when valuations mean-revert. However, this approach can also increase the fund's exposure to stocks with deteriorating fundamentals. This is because the metrics it uses to weight its holdings are backward-looking and slower to detect souring prospects than market prices. To reduce the market-impact cost of rebalancing and the risk of poor timing, the fund refreshes a different fourth of its portfolio each quarter.

This is a well-diversified portfolio, with limited exposure to firm-specific risk. However, strategy does not constrain its sector weightings. Rather, it attempts to take advantage of mean reversion in valuations, regardless of where they occur.

So far, this approach has worked fairly well. From its inception in August 2013 through November 2018, the fund outpaced the Russell 2000 Index by 33 basis points annualized. This was partially attributable to more-favorable stock exposure in the industrials sector.

Portfolio Construction

This is a well-crafted, fundamentally weighted strategy that systematically rebalances into stocks as they become cheaper relative to their peers, supporting a Positive Process rating. The fund employs full replication to track the Russell Fundamental U.S. Small Company Index. The construction approach begins with the Russell Global Index. Russell screens out the least-liquid stocks from this index. It then assigns fundamental weightings to each remaining stock based on leverage-adjusted sales (sales times book equity/assets), retained operating cash flow, and dividends plus share repurchases. Russell uses the five-year average for each metric and takes the average of the resulting three values to determine each stock's fundamental size. Stocks representing the smallest 12.5% of the eligible universe go into the Russell Fundamental Global Small Company Index. The Russell Fundamental U.S. Small Company Index includes the U.S. stocks from this global index, and it weights each holding in proportion to its fundamental size. Russell divides the index's portfolio into four equal slices and rebalances a different slice each quarter. This approach helps reduce the market-impact cost of rebalancing and the risk of poor timing. As an additional precaution, the index limits its weightings so that it holds only a small portion of each stock's floated shares.


Schwab charges a 0.25% expense ratio for this fund, making it the cheapest fundamentally weighted strategy in the category. Therefore, it earns a Positive Price Pillar rating. The managers generate ancillary income for the fund through securities lending. As a result, the fund lagged its benchmark by 21 basis points during the trailing three years through November 2018, slightly less than the amount of its expense ratio.

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