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Should I Invest in Schwab’s Fundamental Index Funds?

A reader writes in, asking:

“I currently use three Schwab ETFs for my portfolio: Schwab U.S. Broad Market, Schwab International Equity, and Schwab Short-Term U.S. Treasury. But I’ve been reading about their Fundamental Index Funds and ETFs as well. The idea of allocating to companies according to sales and cash flow makes a lot of sense to me. Do you think it would be prudent to add some of these funds to my existing holdings?”

As a bit of background information: Traditional index funds (and ETFs) are market-cap weighted. This means that each stock (or bond) held in the fund is held in proportion to its market capitalization (i.e., the total market value of the company). For example, if Verizon makes up 1% of the U.S. stock market, a market-cap weighted U.S. “total market” index fund would have 1% of its portfolio invested in Verizon.

In contrast, “fundamental” index funds (and now, in some cases, “smart beta” funds) weight companies according to their “fundamentals” (i.e., metrics such as sales, cash flow, or net income).

While I don’t think its typically useful to compare the performance of two funds in order to see which fund is better (remember, picking based on past performance is often worse than picking randomly), I do think it can be helpful to plot the performance of two funds on the same chart to see how similar they are.

For example, with these various new types of not-so-passive index funds, it’s often enlightening to:

  • Look at where the fund falls in the tic-tac-toe-looking Morningstar style box (i.e., growth vs. value and small-cap vs. large-cap),
  • Find a plain-old Vanguard fund with a comparable position in the style box, and
  • Plot the two funds together on the same growth chart.

With regard to the reader’s question, let’s run through the above exercise with three Schwab Fundamental Index Funds.

Our first chart shows the Schwab Fundamental US Large Company Index Fund (SFLNX, in blue) and the Vanguard Large-Cap Index Fund (VLCAX, in orange), since the inception of the Schwab fund:

Large-cap

The following chart shows the Schwab Fundamental US Small Company Index Fund (SFSNX, in blue) and the Vanguard Small-Cap Index Fund (VSMAX, in orange), since the inception of the Schwab fund:

Small-Cap

And the final chart shows the Schwab Fundamental International Large Company Index Fund (SFNNX, in blue) and the Vanguard International Value Fund (VTRIX, in orange), since the inception of the Schwab fund:

International

You can see periods in each of these charts in which one fund outperforms the other, but the overwhelming takeaway that I see is simply how very similar the funds are.

And that’s typically how it goes when I look at a fund in one of these newer categories. They’re usually perfectly fine funds. (After all, going toe-to-toe with a low-cost index fund from the most respected provider of index funds is nothing to laugh at!) But there’s usually little substance behind the marketing message that these are a distinct improvement over traditional index funds. For the most part, they’re simply a new way of arriving at the same old portfolio (or very close to it).

Investing Blog Roundup: Buying Insurance

This week, I enjoyed three articles about buying insurance. Karen Haywood Queen shares a strategy for saving money on life insurance. Jim Dahle warns against a common (but poorly-reasoned) sales pitch for life insurance. And Michael Kitces offers a guiding overall philosophy on when and when not to buy insurance.

Investing Articles

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When to Tax-Gain Harvest Your Bonds

Last week’s article about tax-gain harvesting with bonds drew quite a bit of correspondence from readers. (To recap, the general idea is to sell a bond that has increased in value since you bought it — and which you have held for more than one year – and reinvest the proceeds in a similar, newly-issued bond with a comparable remaining maturity. In doing so, you effectively convert some of the interest income into long-term capital gain income, which is often advantageous due to the fact that long-term capital gains are taxed at a lower rate than ordinary income.)

The primary question readers had was: Are there cases in which it would not make sense to use such a strategy?

And the answer is that, yes, there certainly are some cases in which it wouldn’t make sense to tax-gain harvest your bonds.

For example, the desirability of the strategy depends on what type of bond we’re talking about.

  • It is most likely to make sense with corporate bonds,
  • It is less likely to make sense with Treasury bonds, because the interest on Treasury debt is free from state income taxes, whereas the capital gain income would, in most cases, be taxable at the federal and state levels, and
  • It is almost never going to make sense with muni bonds, because muni bond interest is tax-exempt at the federal level, whereas the capital gain income would be taxable at the federal and state levels.

In addition, there’s the possibility that something else tax-related would make you want to avoid increasing your income this year. For example, if there’s a particular tax credit for which you currently just barely qualify, but the capital gain would push your income over the eligibility threshold, tax-gain harvesting this year is unlikely to be advantageous. Or, if you’re a retiree collecting Social Security, and your income level is currently at a point where your Social Security is nontaxable — but realizing a capital gain would push you into the range where a significant portion of your benefits would be taxable this year — that’s a point against tax-gain harvesting.

In general, the analysis that you want to do is figure out how big the tax increase would be this year (due to the capital gain income) and how big the savings would be in future years (due to the reduced level of interest income). To get the best analysis possible at a DIY level (i.e., without paying a professional to assess the situation for you), it probably makes sense to do a test-run through TurboTax (or something similar) comparing each approach (selling vs. holding) for the years in question.

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Investing Blog Roundup: 20 Years of the “4% Rule”

The retirement planning concept of “safe withdrawal rates” (and the accompanying “4% rule” concept) can be traced back to an article by financial planner Bill Bengen — an article that was published 20 years ago this month (October, 1994). This week, the Journal of Financial Planning published a piece by financial planner Jonathan Guyton (with additional perspectives from a number of other big names in the retirement planning field) discussing the impact of Bengen’s research.

Investing Articles

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Tax-Gain Harvesting with Bonds

Tax-loss harvesting is a very common tax strategy in which you sell a holding when its value is less than the amount you paid for it, then reinvest the proceeds from the sale in a similar (though not “substantially identical”) investment. The idea is that you then get to use the capital loss (up to $3,000 per year) to offset ordinary income on your tax return, without having to make any significant change to your portfolio.

Tax-gain harvesting is a somewhat less common strategy, as it’s generally only helpful for people in the 15% tax bracket or below. The idea is to sell a long-term holding for a gain, then reinvest the proceeds in a similar investment. The benefit comes from the fact that, if you’re in the 15% tax bracket or below, you do not have to pay any tax on the long-term capital gain, and now your cost basis in the asset has increased to the asset’s current value, thereby reducing the size of the capital gain that you might have to pay tax on in the future.

There is, however, a form of tax-gain harvesting that can be helpful even to investors who are in a tax bracket higher than 15%. It becomes relevant when you’ve held a bond for more than one year, and it is currently valued at a price higher than what you paid for it (i.e., the price has gone up because interest rates have fallen since you purchased the bond).

The idea is that, rather than holding the bond and continuing to receive payments at the bond’s higher-than-market interest rate, you sell your bond at a premium, then reinvest the proceeds in a bond that:

  • Has a similar credit quality and remaining maturity (so that you’re not changing the risk of your portfolio), yet
  • Is selling at (or very close to) its par value (e.g., because it’s a new bond).

By doing so, you essentially convert a portion of the yield that you would have received as interest into a long-term capital gain, which will be taxed at a lower rate than the interest income would have been. While it does result in having to pay the tax sooner than you otherwise would have had to (which is generally not a good thing), taking advantage of the difference in tax rates often allows you to achieve a higher after-tax return.

Investing Blog Roundup: Active Management Risk

The big news last week and early this week was the abrupt departure of legendary bond fund manager Bill Gross from PIMCO. (For those who don’t bother to learn the names of mutual fund managers: Bill Gross was one of founders of the company, and he ran the firm’s Total Return fund for many years with very impressive performance.)

This event is the perfect example of the “management risk” that investors in actively managed funds have to deal with. That is, investors in the fund now have to decide whether they should follow the fund manager to his new fund, stick with the fund without the legendary manager, or do something else entirely.

Jason Zweig and Allan Roth discuss the situation (and accompanying lessons to be learned) this week:

Investing Articles

Other Money-Related Articles

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