As demand for smart beta products continues to surge, Anthony Davidow, vice president for alternative beta and asset allocation strategist at the Schwab Center for Financial Research, believes fundamental indexing is one of investors' smartest strategies.

The bull market has entered its sixth year and the time is ripe for fundamental indexing strategies to outperform, writes Davidow in his latest white paper, "Why Fundamentals – Why Now".

“We think fundamental indexing has a lot of rigor, it’s battle-tested,” Davidow says. “Guys like Rob Arnott have been at this for quite some time. Fundamental indexing was one of the first strategies to challenge the conventional wisdom that market-capitalization strategies are the ideal, it allows us to rely on academic research that shows there are certain factors in the market which can lead to excess returns.”

Fundamental strategies allow investors access to companies exhibiting strong financial and business traits. Whereas traditional index-based strategies are pegged to benchmarks such as the S&P 500 and weighted by market capitalization, fundamental strategies weigh securities based on a variety of factors, including adjusted sales, cash flow, and dividends plus buybacks.

Morningstar estimates that there are nearly 400 exchange-traded products and $400 billion in assets in strategies that they characterize as strategic beta, a categorization that includes equal-weighted portfolios and other non-capitalization weighted strategies.

“We are fans broadly of this strategic beta landscape because it changes the way you get exposure to the market, but not all strategies are created equal,” Davidow says.

“With fundamental indexing, we’ve seen a track record that plays out over time to produce excess returns,” he says. “Other strategies may not have that track record. Many of them invite biases.”

Davidow acknowledges that market capitalization-based strategies do well when the markets are improving.

“In the early stages of a bull market, merely being exposed to the market allows for great growth in client portfolios,” Davidow says. “Over time, you saw a lot of momentum, high-flying names trading at higher prices. As those names get bigger, they become more highly weighted without a sense of whether they are a good value.”

Market capitalization indexes are biased towards larger-cap securities and will experience momentum overtime, while fundamental indexes tend to have a value tilt.