Fundamental Fun With This ETF

Smart or strategic beta exchange-traded funds come with different methodologies. Some focus on a single factor, while others offer investors exposure to multiple factors. Then there are those funds that select holdings based on factors such as a company's ability to generate cash, pay and raise dividends and other profitability metrics.

The Schwab Fundamental U.S. Large Company Index ETF FNDX resides in the latter category, as many of the $945.6 million ETF's 631 holdings are either voracious buyers of their own shares, consistent dividend payers and raisers or both.

A recent survey by Create-Research found that smart beta ETFs account for over $300 billion, or 18 percent of the U.S. ETF market— by far the largest ETF market in the world.

Related Link: An ETF That Cements The Case For Smart Beta

Looking Closer AT FNDX

For its part, FNDX has seen its assets under management tally roughly triple over the past two and half years. The ETF has returned 5.7 percent since coming to market in August 2013. FNDX follows the Russell Fundamental U.S. Large Company Index and resides in Morningstar's large-cap value category, though is home to a fair amount of mid-cap names.

FNDX “weights its holdings based on fundamental measures of size, including sales (adjusted for leverage), retained operating cash flow, and dividends plus share buybacks, rather than market capitalization. This causes the fund to overweight stocks trading at low multiples of these metrics and underweight stocks trading at higher valuations. At times, these active weightings can add up to sizable sector bets. The fund currently has less exposure to the financial services and real estate sectors than the Russell 1000 Value Index, and greater exposure to telecom, and consumer defensive, and cyclical stocks,” said Morningstar in a recent note.

Sector Weights

It would appear FNDX also has something of a quality tilt, one a critic could argue is belied by the ETF's 13.5 percent weight to energy stocks, its second-largest sector allocation. Exxon Mobil Corporation XOM, the largest U.S. oil company, is FNDX's largest holding at a weight of 4.8 percent.

FNDX has portfolio turnover of 12.3 percent as of the end of January, which is somewhat higher than typical broader market ETF that is not a smart beta fund, but there is method to the madness here. And that method helps FNDX skirt stocks that have become too richly valued.

Currently, FNDX's largest sector weight is 14.1 percent to technology, with Microsoft Corporation MSFT and Apple Inc. AAPL being the largest holdings hailing from that sector. That makes sense, as mature technology companies have become value plays in recent years.

FNDX “may be a suitable core holding for long-term investors who can stomach a little extra volatility to profit from potential market mispricings or a risk premium associated with lower valuations. Over the long run, betting on value has paid off in nearly every market studied. Investors may extrapolate past growth--or lack thereof--too far into the future, which can push prices away from fair value. Fundamental weighting counters this bias by removing the link between market prices and portfolio weightings,” added Morningstar.