Funds that mirror Standard & Poor's 500-stock index aren't putting up inspiring performance right now. And new approaches to indexing are cropping up to capture investors' attention. Still, it's hard to argue with the tried and true. By Steven Goldberg, Contributing Columnist March 21, 2006 When they're talking with one another, mutual fund marketers don't talk about funds. They talk about "products." The buyers of those products aren't customers or clients. They're "retail." The marketers are always racing to fashion new, glitzier products for retail, rush them to market and hope the dollars pour in. This is particularly true when an existing product encounters a rough patch. I think funds that are based on "fundamental indexing" are just such inventions. They're new, alluring, and being marketed to investors at a time when funds that mirror Standard Poor's 500-stock index are experiencing one of their occasional periods of lousy performance in comparison with actively managed funds. The father of fundamental indexing is Robert Arnott. His quibble with most traditional indexes, such as the SP 500, is that they are capitalization weighted. In other words, the amount of each stock in the index is based on a stock's market capitalization (share price multiplied by number of shares outstanding). In times of market froth, such as the tech bubble of the late 1990s, these kinds of indexes can be disproportionately weighted with companies that have little or no earnings or sales -- that is, companies with little fundamental value. Arnott's solution: Create a 1,000-stock index based on size -- specifically, the amount of a company's cash flow, revenues, book value and dividends. He and his colleagues then back-tested their new index over the past 40 years. Surprise, surprise. Their index returned more than two percentage points per year more than the SP 500 did. Not only that, it delivered those returns with lower volatility than the SP. Advertisement Last year, two versions of Arnott's fundamental index were launched. Pimco Fundamental IndexPlus Total Return D (PIXDX), a traditional mutual fund, charges 1.14% annually (the D shares are available at many discount brokers without sales charges). PowerShares RAFI U.S. 1000 (PRF), an exchange-traded fund, costs 0.6%. But the fundamental index probably isn't as good as it looks on paper. In an article in the March issue of the No Load Fund Analyst newsletter, analyst Baie Netzer concludes that the main reason the back-tested new index did so well is that it has a value tilt -- that is, it loads up more on undervalued stocks than does the SP 500. Academics for years have known that value stocks and small-cap stocks tend, over the very long haul, to modestly outperform growth stocks and stocks of larger companies. What's more, large-company stocks have lagged those of small-company stocks the past six years, and that period has been particularly cruel for large-cap growth stocks. When growth stocks recover, the long-term outperformance of the fundamental index will likely grow much smaller -- perhaps not enough to make up for the relatively high expense ratios of the two funds (the 0.6% expense ratio of the Powershares fund is high for an ETF). And there are much better ways to capture the excess returns of small-cap and value stocks -- namely by putting some of your money in actively managed funds or index funds that invest in either value or small-cap stocks. In addition, I am skeptical of back-tested numbers of any kind. Anyone can experiment with countless different portfolios until he or she stumbles across one that yields exceptional back-tested results. But there's no assurance that such a portfolio will continue to do well. I want to see real results in the market before I buy any product. Advertisement Rydex SP Equal Weight (RSP), an ETF, is another, simpler way to play this same game. Rather than weighting the stocks in the SP by their market cap, the fund, which was launched in 2003, weights them all equally. Annual expenses are 0.4%, and the fund has beaten the SP handily since inception. Why has it done so well? Because the past several years have been wonderful for smaller-cap stocks, which get a bigger weighting in this index. My bottom line on both of the new funds: They're gimmicks. The SP 500 is a predominantly large-cap index. When large caps -- particularly stocks of large, growing companies -- bounce back, as they inevitably will, the SP 500 will perform much better relative to the upstart indexes. The long-term record, of course, is quite clear: The SP has beaten the overwhelming majority of actively managed funds over the past ten and 20 years. It's a good choice for your large-cap money. Opinions expressed in this column are those of the author.