Proponents of fundamental indexing say it beats
traditional market-cap-weighted measures.

With all the new ETFs and index funds being launched these days, are people going to pay attention to yet another way to slice and dice the market? Supporters of fundamental indexing think they will.
Traditional cap-weighted indexes such as the Standard & Poor's 500 weight each company in proportion to the total market value of its shares, so companies with higher market capitalizations have a greater influence on returns than those with smaller ones. By contrast, companies in fundamental indexes claim space according to financial characteristics that stock analysts might look at, without regard to share pricing.
The differences between the two methodologies are more than a matter of semantics. The composition of a fundamental index is likely to be very different from that of its corresponding market-cap-weighted index, and performance between the two can diverge widely. Research by Robert Arnott, chairman of Research Affiliates LLC in Pasadena, Calif., and editor of Financial Analysts Journal, calculates the benefit to eliminating the "return drag" of cap-weighted portfolios at an average of more than two percentage points annually over the 43-year testing period. In inefficient markets where there is a disconnect between stock prices and company fundamentals, the performance gap in favor of fundamental indexing has been significantly higher.
Arnott, whose research opened the debate between capitalization-weighted versus fundamentally weighted indexes less than two years ago, says his newer methodology represents a more grounded way of addressing the question of how best to achieve broad market representation. "Fundamental indexing reflects a more rational view of a company's success by looking at factors that are reliable signs of a company's strength, such as sales and profits, rather than a narrow view focused simply on how much the market thinks a company is worth," he argues.
Supporters of Arnott's methodologies say the traditional cap-weighted approach tends to overweight overvalued stocks and underweight undervalued stocks, making those indexes more susceptible to market "noise," or fluctuation in stock prices that have nothing to do with changes in company fundamentals. By eliminating that noise, fundamental indexes are able to provide a better mirror of the broad economy. Each stock's weighting in the Research Affiliates Fundamental Indexes (RAFI) is based on a composite five-year measure of dividends, sales, profits and book value. Companies that have paid no dividends in the past five years are weighted in accordance with the other three metrics.
Investors haven't had much time to test drive fundamental index-based products, or to weigh Arnott's claims of their superiority over market-cap-weighted investments. The first investment based on fundamental indexes, the PowerShares FTSE RAFI U.S. 1000 Portfolio, was introduced in December 2005. The exchange-traded fund is comprised of the largest U.S.-listed companies by fundamental value. Another broad market offering, the PowerShares FTSE RAFI U.S. 1500 Small-Mid Portfolio, was launched in September 2006 along with nine sector fundamental-index ETFs.
The PowerShares ETFs that use Arnott's indexes have $1.2 billion in assets. All together, Arnott's firm manages or sub-advises some $8 billion in assets. Another firm specializing in fundamental indexing, WisdomTree Investments, develops and sponsors products based on its own proprietary indexes. 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 and has approximately $3.1 billion under management.
While the multitrillion-dollar index fund industry dwarfs those numbers, the fundamental indexing market got what promises to be a huge boost with the April introduction by Charles Schwab Corp. of three mutual funds based on Arnott's indexing strategies. In a press release, Charles Schwab called fundamental indexing "the most important innovation in passive investing since indexing was popularized in the 1970s," and predicted, "We'll look back at this innovation as a watershed moment for the mutual fund investor and for the $5 trillion index fund industry." He expects financial advisors to be early adopters of the strategy, with individuals following suit over the next five to ten years.
Whether investors will view Schwab's statement as product push or prophecy depends largely on whether the ETFs and the mutual funds perform against their market-cap-weighted counterparts as well in the coming years as they have in the past. Back-testing indicates that over the ten years ended March 1, the FTSE RAFI 1000 Index had an average annual return of 11.84% compared with 7.63% for the S&P 500 Index. The FTSE RAFI 1500 Index's ten-year average annual return of 15.31% beat the 9.58% return for the Russell 2000 by an even wider margin. Although no publicly available fundamental index investments are available for emerging markets, Arnott says that an index he constructed and back tested for 13 years would have outperformed the cap-weighted emerging markets index by an average of ten percentage points a year.
"The most interesting opportunities in fundamental indexing are in more speculative markets where fair value is uncertain and there are likely to be greater pricing errors," he says.
Judging by their opposition to Arnott's strategy, some of the industry's biggest indexing powerhouses aren't taking the threat of new fundamental indexing products lightly. In an opinion piece published in The Wall Street Journal, Vanguard founder John C. Bogle and noted author Burton G. Malkiel wrote that the fundamental index ETFs have higher turnover and higher expenses than their market-weighted counterparts, and that much of their outperformance is attributable to their bias in favor of value and small-cap stocks. While the market has generally favored those kinds of stocks since 2000, the performance advantage of fundamental indexing could evaporate when the markets rotate back to growth stocks, they assert. 
Others say the strategy's stock selection process makes it something other than an index. "We feel fundamental indexing is rudimentary active management," says Lance Berg, a spokesperson for Barclays Global Investors. "It's going to outperform the broad market over some periods and underperform over other periods." Most of Barclays' large stable of exchange-traded index funds are market-cap-weighted, although Berg says the firm is weighing the possibility of offering actively managed ETFs.
Arnott says critics of fundamental indexing are looking at issues from a different perspective than he is. "I would argue that cap weighting has a structural bias toward growth, and that fundamental indexing is a flat-to-neutral strategy," he says. "Relative to cap-weighted indexes, fundamental indexes will always look like they have a value tilt." Although his firm's indexes average around a 10% annual turnover, none of the fundamental index PowerShares ETFs have made a capital gains distribution, and he's "optimistic that they never will." And while the ETFs have slightly higher expenses than some market-cap-weighted funds, he says that the small difference is worth the value added in terms of performance.
"There is room for both perspectives here," he maintains. "If someone agrees with the basic principles of fundamental indexing, it might make sense to put one-quarter to one-half of an indexed portfolio into those products."