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.

“In the latter stages of a bull market, you’re better off screening based on financial markers,” Davidow says. “They will provide better valuations and discernment going forward than they have in the past.”

Due to the extended bull market, Davidow argues that market-cap indexes are overvalued with a “substantially higher” price-to-earnings ration than fundamental indexes. While markets may be expensive towards the end of a bull market cycle, Davidow argues that there are some securities that are still cheap or fairly priced, and fundamental indexing allows those securities to receive a greater weight than market-cap strategies.

Andy Kapyrin, director of research at Morristown, N.J.-based Regent Atlantic, argues that fundamental strategies can help hedge against overvaluation.

Like market-cap indexes, fundamental indexes change when companies are added and removed through reconstitution, but fundamentals regularly rebalance through a strategic, disciplined approach, selling companies that have appreciated the most and buying others that may have been out of favor, he says.

“Investors tend to over-concentrate in bad investments that have done well recently,” Kapyrin says. ““Fundamental forces investors to rebalance and buy something htat has dropped and sell something that has risen, cutting against a human risk-aversion trait.”

Because this process does not involve the feelings of investors or portfolio managers, it avoids the gambles that active managers occasionally take, but it still represents a higher-risk strategy than market cap strategies.

“Today, with fundamental indexing, they’ll be rebalancing into more energy stocks because they’re cheaper than they used to be and their fundamentals have not changed as much as their prices,” Kapyrin says. “They’ll be selling out of technology like Amazon and Google even though many investors will want to hold onto those stocks. It seems counterintuitive, but fundamentals are always buying things that make folks uncomfortable.”

Davidow likens the mechanism to a blend of passive index strategies and active management.

“In certain environments, active managers can help, especially in playing defense,” Davidow says. “We believe that all of these strategies have a role in the portfolio.”

Fundamental indexing’s excess returns come from both the screening and weighting methodology and the periodic rebalancing of the index, Davidow says. With the proliferation of fundamental index ETFs, including six introduced by Schwab over the past two years, the strategy can now be employed at low cost.

“The growth in these strategies began in big institutions seeking index-based exposure but not seeking it in traditional fashion,” Davidow says. “More recently, with the proliferation of ETFs, a lot more individual investors and advisors have been using fundamental strategies in a larger way.”

Davidow cites Schwab research that shows that 60 percent of RIAs plan to invest in fundamental index strategies, and nearly a quarter of RIAs plan to increase their allocation to fundamental strategies.

“ETFs are elegant building blocks and they are good ways to access markets in an efficient fashion,” Davidow says. “They’ve been embraced by advisors because they make it easier for them to build portfolios.”

But fundamental indexing isn’t a panacea – during extended boom periods like the tech bubble, when valuations become elevated, fundamental indexing tends to lag behind market capitalization.

“In those environments, it’s challenging for fundamental indexing to perform as well. There are periods where fundamental indexing will lag,” Davidow says. “There’s a role for both. They’re better together and they naturally complement each other.”

Davidow promotes an approach to portfolio allocation that places fundamental indexing among other strategies.

“We’re not saying that there aren’t other good strategies. We’re saying that they’re different,” he says. “We’re trying to educate inevstors so that they can make better-informed decisions. More choices are good, but it also increases the need for better understanding and education”