If you are invested in Schwab Intelligent Portfolios®, consider this alternative.

Investors are getting the message to invest in index funds. Companies are offering more index funds, which is great, but now investors are confused about which type of index fund to select.

The amount of money in index funds has grown exponentially since I entered the business 15 years ago.

About 20% of all assets in the U.S. were in index funds in 2007. By 2017, that grew to 45%. The remaining investments are in active funds where a manager is picking a portfolio of stocks and trying to outperform the market, versus passive funds that are tracking an index. Researchers, educators and the financial press have confirmed the reality - the majority of active managers don't beat the index over the long-term, and if they do, not by enough to justify their fees. Those that do outperform can't do it consistently - only 7% of the funds in the highest quartile of active U.S. stock funds in September 2015 were still among the top 25% 3 years later. If you lengthen the period to 5 years, that percentage drops to 1.5%.

Investment companies are meeting the index-fund demand - but still figuring out ways to get paid.

If you are using Schwab Intelligent Portfolios®, you hold "fundamental" index funds. The "fundamental" funds are index funds, but they are more expensive than other index funds. Here are 2 emerging market funds Schwab offers.

All data as of 5/21/2019 from ETF.com.

All data as of 5/21/2019 from ETF.com.

The debate is no longer about active versus passive - passive is taking over. Instead, it's about which type of indexing methodology is best.

An index is a group of securities that represent the risk and reward characteristics of a given market segment. For example, the S&P 500 Index is an index made up of 500 of the largest U.S. stocks. You can't invest directly in an index, but you can invest in a mutual fund or exchange traded fund (ETF) that replicates the index's movements. For example, if you want to track the S&P 500 Index, you can invest in the ETF with ticker SPY.

Here are 4 common indexing methodologies.

Market-cap weighted

Market-cap weighted indexes assign more weight to bigger companies. Size is determined by market capitalization, which is a formula of the company's price multiplied by the number of shares they have outstanding. An example of this type of index is the S&P 500. The largest holding is Microsoft with about 4% of the portfolio. Market-cap weighted index funds will have the lowest cost or expense ratio (about .1% or lower). The remaining 3 methodologies are more expensive because they need to be rebalanced more frequently.

Fundamentally-weighted (or "smart-beta")

Schwab Intelligent Portfolios® holds your money in this type of an index. The holdings and their percentages are based on financial valuation metrics such as earnings, revenue or assets. These funds will cost about .3%-.4% - cheaper than active funds, but not as cheap as market-cap funds. Fundamentally-weighted indexes end up tilting you towards smaller-cap and value stocks.

Equal weighted

This type of index assigns the same weight to each constituent in the index. For example, each stock in the S&P 500 Equal Weight Index will be 1/500th of the overall index. Compared with market-cap weighted indexes, these indexes will be more heavily concentrated in smaller companies.

Dividend-weighted

This type of index weights holdings based on their current or expected dividend. Stocks that don't issue a dividend, such as Google, will be excluded.

Schwab's fundamental emerging market fund’s (FNDE) expense ratio is 3 times as much as the market-cap weighted fund. Is that price differential justified?

Much of the research supporting "fundamental" or "smart beta" strategies is too short or based on hypothetical, back-tested data, which isn't predictive of what will happen in the future. Vanguard research tackled the topic and concluded that traditional market-cap weighted indexes are the best approach in that they include all factors, not just select factors that tend to skew the portfolio towards smaller-cap and value. If you want that tilt, you can do it yourself at virtually no cost by purchasing a market-cap weighted small-cap value index to supplement your total market index holding.

There is a "smart" complement to market-cap indexing. It's one that promotes transparency among public companies and progress on ESG issues.

There is a risk that none of the above indexes are capturing - and that is climate-related risks and physical damage relating to extreme weather events.

  • Hank Paulson, the former CEO of Goldman Sachs and U.S. Treasury Secretary during the financial crisis said he's struck by the similarities between our current climate crisis and the financial crisis of 2008.

  • Blackrock, the world's largest asset manager, has invested heavily into climate research in an attempt to gain more visibility in terms of the shocks we can expect in the financial markets due to climate change.

  • MSCI, an index provider and ratings agency, engages and rates companies on how they are managing their exposure to environmental, social and governance (ESG) factors.

The demand for understanding these risks has led to solutions that anyone can invest in. MSCI's ESG Extended Focus Indexes, for example, start with a market-cap weighted index but adjusts percentages based on how a company is handling ESG issues. A company that spends money now to protect their infrastructure and supply chains for extreme weather events may receive a higher ESG rating, and therefore a higher weight in the index than in a pure market-cap or fundamentally-weighted index. Social factors, such as diversity and human rights, and governance factors, such as management structure and executive compensation, are also taken into account.

If you're invested in Schwab's fundamental ETFs - consider ESG-investing instead.

It is cheaper (.1-.2%) and addresses a risk that is not being captured with fundamentally-weighted indexes. What does the research say? In over 2,000 independent studies, ESG-investing has been proven to yield similar risk-adjusted returns to traditional investing, if not better. That makes more sense than paying triple the price for a small-cap value tilt.

If you're clear on what you want to achieve but not clear on how to implement, our ESG Investment Managers can help whether you are in Memphis, San Diego, or beyond.