You could call it the Battle of the Indexers. On one side are investors who believe traditional market-cap-weighted index ETFs have withstood the test of time and continue to represent the most efficient way to invest in the markets. On the other side stand the growing ranks of alternative indexers who question the efficacy of market cap weighting and believe there are better ways to skin the indexing cat.

In many ways, they are both right. While the newer indexes eliminate some of the inefficiencies of market-cap weighting, they also introduce their own biases. And while they have often outperformed their market-cap-weighted siblings since their introduction over five years ago-a point that the ETF sponsors often highlight in presentations to advisors-they can also be more volatile.

The seeds for alternative indexing were planted back in the beginning of 1998, when technology stocks were just beginning to bubble. At the time, the sector made up 13% of the S&P 500 index. By March 2000, after the tech boom, they accounted for nearly one-third of that sector allocation. The techastrophe that ensued soon afterward launched a new line of thinking by highlighting what alternative indexing advocates consider a fundamental flaw of traditional market-cap-weighted indexes: that they overweight overvalued companies and underweight undervalued companies.

Since then, ETF providers have been busily launching funds based on what they consider new and improved indexes. Depending on their framework, they might rejigger existing components of market-cap-weighted indexes, use the parts that fit their styles and add a dash of their own seasoning, or start fresh altogether.

Fundamentally weighted and equal-weighted indexes have emerged as the dominant challengers to traditional market-cap-weighted products. Together, the ETFs that follow these alternative strategies had some $40 billion in assets in 140 products at the beginning of this year, according to ETF commentary and research site IndexUniverse.com.

In an equal-weight index, each stock or sector component makes up the same percentage of the index. For example, the oldest and largest equal-weight index, the Rydex S&P Equal-Weight ETF (RSP) does what its name implies by taking the component stocks in the S&P 500 index and giving them roughly equal billing.

Tony Davidow, managing director at Rydex SGI, says that equal weighting avoids the problem of emphasizing one stock or sector too heavily, while the practice of quarterly rebalancing helps weed out overvalued stocks. "If you're trying to 'own the market,' it makes sense to have a broad-based representation of what the market is," he maintains.

Fundamental indexing adds a layer of complexity by selecting indexing components based on financial screens such as earnings, dividends or a composite of such criteria. Unlike equal-weighted indexes, which invest in market-cap index components in different proportions, the fundamental indexes sometimes draw from a different pool of securities. Because of the different holding criteria, fundamental index ETFs can differ greatly from one other in composition and performance, besides differing from market-cap-weighted indexes.

PowerShares introduced the first fundamental index ETF in 2005, the FTSE RAFI U.S. 1000 Portfolio (PRF). Based on methodology developed by Research Affiliates LLC, the ETF allocates stocks in the Russell 1000 Index based on a combination of book value, cash flow, sales and dividends. The firm has a total of six fundamental index ETFs based on Research Affiliates' methodology.

WisdomTree, another indexing stalwart, puts its own spin on indexing by emphasizing cash dividends or earnings. That firm, with former hedge fund manager Michael Steinhardt serving as its chairman and Wharton professor Jeremy Siegel as its senior investment strategy advisor, launched its family of ETFs in June 2006. Other major ETF sponsors such as Schwab, Vanguard, State Street and BlackRock also have a smattering of alternative index products in their lineups that use a variety of criteria to build components.

A comparison of the Rydex S&P Equal Weight and PowerShares FTSE RAFI U.S. 1000 Portfolio to corresponding market-cap-weighted index products illustrates the pros and cons of each approach. Over the five years ending December 31, 2010, the Rydex fund had an average annualized return of 4.16%, compared to 2.28% for the SPDR S&P 500 ETF (SPY). Rydex held the edge largely because of its greater emphasis on smaller companies and sectors with a large number of small constituents, such as consumer discretionary.

Over the same period, the PowerShares offering had an annualized return of 4.27%, compared to 2.54% for the market-cap-weighted iShares Russell 1000 Index ETF (IWB). In this case, the alternative index ETF benefited from a tilt toward value and smaller companies.

However, both PowerShares FTSE 1000 and Rydex S&P Equal Weight underperformed their market-cap-weighted counterparts in the downturn of 2008. And in a market that favors large-cap or growth stocks, the market-cap-weighted ETFs would likely outperform.

"Enhanced or fundamentally weighted indexes seek to outperform the market," notes Morningstar analyst Michael Rawson. "But to do this requires risk-taking and the ability to endure periods of underperformance."

One area where market-cap-weighted indexes win hands down is cost. While market-cap-weighted fund expenses range from 0.06% to 0.28%, the alternative offerings clock in with expenses of 0.23% to 0.88%.

Tax efficiency is another issue. Because alternative index ETFs need more frequent rebalancing to follow their strategies than their market-cap-weighted counterparts, their turnover rates of 15% to 30% are somewhat higher than the 3% to 15% annualized turnover for market-cap-weighted ETFs. That's still well below the turnover rates of 100% or more for actively managed funds. So far, at least, the tax-efficient ETF structure has made it possible for the alternative funds to avoid paying out significant capital gains, says Matt Hougan, president of analytics for exchange-traded funds at IndexUniverse.

Advisors who have migrated into the new indexes say they are pleased with them thus far. And they are finding their own unique ways to use them.

Christian Wagner, chief executive officer at Longview Capital Management in Wilmington, Del., began using an equal-weight S&P 500 ETF as a core position in April 2009. As the market began pulling up, he reasoned, the small-cap and mid-cap bias in the equal-weight ETF would put it in a better position to outperform, which proved to be the case.

He hasn't abandoned market cap weighting, though, and would consider switching back if he sees clear evidence that mega-caps are taking a strong lead. "I see the market-cap-weighted ETF as a more defensive position that would be appropriate in the more mature cycle of the market," he says. "The decision to shift between traditional and alternatives indexes is really driven by where we are in the market cycle and where we see relative strength."

Morristown, N.J.-based RegentAtlantic Capital, which manages over $2 billion in assets, has used fundamental index products for its large-cap U.S. and international allocations for over two years, according to Brian Kazanchy, who chairs the firm's investment committee. He believes that weighting stocks based on their fundamental values simply makes more sense than giving a stock more space just because its price has gone up, and he says the strategy has successfully added alpha to client portfolios.

Unlike Wagner, Kazanchy sees the fundamental index allocation as a more permanent fixture in the event market conditions change. At the same time, he continues to employ market cap weighting for allocations to areas such as U.S. micro-caps and emerging markets because he hasn't found fundamentally weighted ETFs or mutual funds with sufficiently competitive expenses.

Despite winning converts, assets in alternative index ETFs and mutual funds remain miniscule compared to those based on market-cap-weighted indexes. And many advisors maintain a fierce loyalty that alternative index sponsors are finding tough to crack.

"Traditional cap-weighted index funds have a long and proud history of treating investors well, which the newfangled index funds do not," says Russell Wild, a financial advisor in Allentown, Pa., and author of Exchange-Traded Funds for Dummies. "In addition, they tend to come with significantly lower management fees, and are potentially more tax efficient due to lower turnover. And lately, as a bonus, they've become largely commission-free to trade at Vanguard and Fidelity."

If Wild wants greater exposure to mid-cap and small caps, he says, he can easily tilt portfolios toward those asset classes without shifting to an equal-weighted index fund. And if he wants to emphasize value or growth, he can do it with a mix of market-cap-weighted funds rather than move to a fundamental index ETF that adheres to those biases.

There is some debate about whether it makes sense to mix different indexing methodologies within the same asset class. Matt Hougan of IndexUniverse, like others, believes that with the relatively high correlations between alternative indexes and their cap-weighted counterparts, taking such an approach provides little diversification benefit.

Portfolio manager Otis Carter of Wells Fargo Advisors in Evansville, Ind., disagrees. He says that the behavior of the dividend-focused WisdomTree ETFs differs enough from their equivalent market-cap-weighted counterparts to "behave like a separate asset class." In their middle-ground growth and income model, for example, the firm blends the two indexing strategies in roughly equal proportion over several asset classes.

"The industry tends to look at ETFs as a product," says Carter. "We consider them as an asset class proxy."