A Fundamentally Better Index?

Index funds have a lot to offer, and I believe most investors should have at least some of them in their portfolios (Good News About Index Funds). They charge little and guarantee that you'll earn the average return for whatever market the index fund is designed to copy. Over time, the average return beats the returns of most actively managed funds.

But something's always bugged me about traditional indexes, and I'm starting to think there's a fundamentally better alternative.

Take Standard & Poor's 500-stock index, the most popular index based on the amount of money invested in funds that track it. Like most indexes, the S&P 500 is capitalization-weighted, meaning that the biggest companies, as measured by their market value (number of shares outstanding times share price), get a larger weighting than smaller companies. At the height of the tech bubble in early 2000, for example, the combined weight of the two top stocks, Microsoft and General Electric, equaled that of the 250 smallest stocks in the S&P 500.

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At its worst, the S&P 500 is a reflection of the herd instinct. Investors pile into the same few stocks -- and keep piling in for the sole reason that the prices of those stocks have been rising precipitously because we keep piling into them. As a result, it's virtually certain that a big chunk of the index will often be in overvalued companies.

Fortunately, fans of index funds now have choices that may be better than traditional, cap-weighted products. For years I've followed the development of "fundamental indexes," which weight stocks by what the investing community calls "fundamentals": such basic measures as sales and profits. For a deeper examination of the phenomenon, see contributing editor David Landis's Reinventing the Index .

Several providers of exchange-traded funds have made a big push into fundamental indexing. For example, PowerShares offers a family of funds based on fundamental indexes, led by PowerShares FTSE RAFI US 1000 (symbol PRF). The funds are based on work by the father of fundamental indexing, Robert Arnott, who relies on earnings, revenue, cash flow and book value to weight stocks.

Another firm, WisdomTree, sponsors ETFs that weight companies mainly according to the cash dividends they pay out. Stocks of dividend-paying companies, it maintains, do better over time. RevenueShares markets funds that weight companies according to their gross sales, an approach that has the effect of overweighting companies with low price-to-sales ratios. Over time, RevenueShares says, shares of such companies perform better than more-expensive stocks.

All of these fundamental-indexing advocates claim to have back-tested data that show that their methods beat cap-weighted indexes over long periods. Of the lot, RevenueShares' method makes the most sense to me, maybe because of its simplicity. Its method de-emphasizes ridiculously overpriced stocks and filters out a lot of the noise that influences other fundamentals -- revenues, for example, are far more stable than profits from quarter to quarter.

The short-term results of most RevenueShares ETFs have been terrific. For example, from the stock market's bottom on March 9 through August 27, RevenueShares Large Cap (RWL), the ETF that competes most closely with S&P 500 index funds, beat the index by ten percentage points; RevenueShares Mid Cap (RWK) beat its bogey by 21 percentage points.

Sean O'Hara, president of investor services for RevenueShares, says back-testing shows that over decades, the firm's methods beat traditional indexes by an average of two to three percentage points per year. But back-testing can amount to little more than cherry-picking from history to build a case. And no smart investor acts on short-term results.

Defenders of traditional indexes have recently published studies dissecting fundamental indexing's flaws.

The biggest criticism of large-cap fundamental indexes is that they merely increase the influence of small companies and undervalued companies, two strategies that perform better over time than buying large growth companies. To this I say: That's a criticism? What's wrong with tilting the portion of your portfolio dedicated to large-company stocks toward something that works?

At any rate, RevenueShares' funds have piqued my interest, and I'll be monitoring how they fare as stocks continue to recover from the devastating bear market. Should the ETFs continue to perform well in more-normal times, I'm ready to jump in.

I'm also interested in another kind of index that isn't cap-weighted but isn't exactly a fundamental index, either. It's an equal-weight index, one that assigns each stock in the S&P 500 the same value. Morningstar found that only 7% of actively managed, large-company domestic stock funds beat the S&P equal-weight index over the past ten years. That is remarkable by itself, but it's even more remarkable when you consider that 62% of active funds beat the regular S&P 500 over the same period.

The cheapest way to buy the equal-weight index is with Rydex S&P Equal Weight (RSP), an ETF. The fund itself doesn't have a ten-year record. But over the past five years through August 27, it returned an annualized 2.4%, beating the regular S&P 500 by an average of 1.7 percentage points per year.