Thirty five years after the first S&P 500 index mutual fund was introduced, the appetite for passive investments continues to grow. But, along with an increased affinity for passive investing has come increasing interest in alternative indexing schemes to the capitalization-weighted approach now dominant in the market.

A recent survey of institutional investors by EDHEC-Risk Institute, a financial research center in Nice, France, found that while investors continue to favor passive investments, more than 50 percent see capitalization-weighted indexes as “problematic.” Forty percent of investors surveyed have adopted alternative indexing schemes, according to Noël Amenc, director of the EDHEC-Risk Institute.

To be sure, capitalization-weighted indexes remain dominant in the marketplace. The Big Three ETF providers in the U.S.—iShares, Vanguard and State Street Global Advisors—primarily provide traditional capitalization weighted ETFs. Morningstar estimates only about 8% of the $1.02 trillion in U.S. and international stock ETF assets are invested in alternative indexes. 

Still, ETF sponsors that provide alternative index ETFs are doing a brisk business. One example is Research Affiliates LLC, which was founded by Robert Arnott, co-author of a 2005 research report that launched the current wave of fundamental indexing. The firm manages $60 billion in assets, up from nothing seven years ago, according to Shane Shepherd, senior vice president and head of fixed income research at the firm. “We’re seeing phenomenal growth in fundamental index strategies,” he says.

In addition to the perennial search for higher returns, one of the main reasons investors are turning to alternative indexing schemes is concern that capitalization-weighted indexes lead investors to buy increasingly expensive stocks as their market capitalization expands.

The first alternative indexing schemes looked to avoid this trap by equal weighting the standard index. More recently, firms such as Research Affiliates, WisdomTree Investments and others have introduced fundamental indexes that seek to avoid the capitalization trap by buying stocks based on fundamental factors that can include dividends, earnings, cash flow, sales, and book value. While major capitalization weighted indexes generally are reconstituted yearly, the ETFs that track fundamental indexes tend to be rebalanced more frequently. WisdomTree, for example, does it semi-annually. 

The result of fundamental approaches to indexing are portfolios tilted towards value stocks and small-cap stocks. That’s partly a function of their rebalancing discipline. These ETFs tend to rebalance out of companies whose stock prices have moved ahead of their fundamentals and into companies whose stock prices have lagged fundamental factors. As a result, fundamental index ETFs tend to have higher turnover as well as higher expense ratios than market cap-weighted ETFs. Because they trade away from large-cap stocks, they also tend to be more volatile

Performance Numbers

Research Affiliates has found that from 1962 through 2012, the annual return of the Research Affiliates Fundamental Index (RAFI) Composite has outperformed the S&P 500 by 2.1% a year––11.5% a year for the RAFI Composite versus 9.4% a year for the S&P 500. “We don’t believe the markets are perfectly efficient,” Shepherd says.

Glamour stocks get overvalued and out of favor stocks get beaten below fundamental value. “A fundamental system, with regular rebalancing, is a great way to take advantage of those inefficiencies,” he says.

Market cap proponents argue that the outperformance of fundamental indexes is nothing more than the result of their small-cap and value tilts, which studies from Dartmouth professor Kenneth French and University of Chicago professor Eugene Fama have shown to provide superior long-term returns.

However, Morningstar ETF analyst Alex Bryan recently wrote that a 50-country study covering the 1982-2008 period found that fundamental indexing added significant excess returns even after controlling for value and other risk exposures. The contrarian bets that fundamental indexes make may contribute to that outperformance, Bryan noted.

The differences between fundamental index ETFs and traditional index ETFs are evident by comparing the PowerShares FTSE RAFI US 1000 Portfolio (PRF) and the Vanguard S&P 500 Index (VOO) funds. Both ETFs are rated Overweight by S&P Capital IQ. PRF has an expense ratio of 0.43%, while VOO costs just 0.05%. Sixty-eight percent of VOO’s $8.5 billion in assets are in mega-cap stocks (stocks with market caps of $25 billion or more), while 57% of PRF’s $1.6 billion in assets are in mega caps. VOO has just 2% in mid-cap stocks, PRF has 10%. 

“This is a large-cap portfolio,” notes Todd Rosenbluth, director of ETF Research at S&P Capital IQ, “so the fund (PRF) has a tilt towards smaller-cap stocks, not actual small caps.” As is typical of such portfolios, PRF’s standard deviation is higher at 19.43% versus 13.04% for VOO.

VOO also is more growth stock-oriented. Information technology constitutes 19% of VOO, while that sector accounts for only 9.42% of PRF. PRF’s biggest weighting is financials at 23.6% of the portfolio.