Schwab Backs Indexing By Will McClatchy March 16, 1999

SAN FRANCISCO, CALIF. - The largest US discount brokerage firm released a study that emphasizes indexing as the core of an optimal long-term equity portfolio. The study by the Schwab Center Investment Research at Charles Schwab & Co. disputes the benefits of an all-actively managed portfolio but still recommends heavy stock picking in small cap and international sectors markets.

"Core and Explore - An effective strategy for building your portfolio' argues that investors should start with indexes and then select managed assets if they want to outperform the markets.

Key research findings include:

• Indexes lower a portfolio's risk
• Partial use of indexes actually improves the chance of beating the average
• Actively managed funds are best used in international and small caps markets

The study claims to be comprehensive, although full details of the study were not released. It is not available for viewing on the Web. For several different asset allocations, Schwab researchers created 1,360 hypothetical portfolios of actively managed funds, an equal number of portfolios with a combination of index active funds, and an all-index portfolio. The researchers tested all the different possible weighting combinations of index and active funds, seeking an optimal balance where performance was more likely to beat the average and to keep volatility to a minimum:

For an aggressive investor, the optimal balance meant placing:

• 80% of large-cap holdings in index funds
• 40% of small-cap holdings in indexes
• 30% of international holdings in indexes

One of the study's more curious conclusions was that adding some index funds to an all-active portfolio actually improved chances of beating the underlying index, up to a point. As index funds continue to be added they tend to push portfolio back down again to the average.

International and small cap funds are the place for investors to choose active management, said the study, because active managers can easily avoid sectors or countries with poor prospects. The study used the Russell 2000 as the small-cap index and the MSCI EAFE as the international benchmark. The latter, especially, heavily weights Japan. In the last decade active managers have handily beaten EAFE by avoiding that country as the Nikkei steadily declined from stratospheric heights.

Charles Schwab earns income selling both index and active funds to investors.