Index investing is many investors' staple. They select a fund that matches a well-known index, and then sit back to watch their investments grow with the market. Now investors have a growing variety of indices to choose from.

Some indices are capitalization-weighted, such as the S&P 500 and Russell 2000. Some indices are price-weighted, such as the DJIA. Based on the efficient market theory (EMT), these indices have been the basis for many investment vehicles for investors including mutual funds and exchange traded funds (ETFs).

The new choices in index investing involve fundamentally weighted indices, such as the FTSE RAFI US 1000 Index, WisdomTree Dividend Index and WisdomTree LargeCap Value Index, which are based on one or more factors such as book value, cash flow, revenue, sales or dividends. These indices offer investors new options for investing their hard-earned capital. Here we look at the benefits and risks of using fundamentally weighted indices as an investment vehicle.

**Capitalization-Weighted Indices**

Let's start with the basis for capitalization-weighted indices to establish some background. The capital asset pricing model (CAPM) is the foundation for a number of index models, especially the capitalization-weighted indices such as the S&P 500. Basically, CAPM assumes that cash flows can be determined into the future on every investment. This helps identify the true value of each security. Because the market is efficient, it will properly match the asset's price to its CAPM-determined value. Efficient market theory states that a stock's price reflects the market's best estimates of the firm's underlying true value at any given time.

**When True Value Isn't True**

But what if the price ends up above or below the "true value"? Does this mean the true value is wrong? Not necessarily, although it does mean that each security will trade above or below its ultimate true value. If every security is trading above or below its true value, then capitalization-weighted indices will be overexposed to securities trading above their true fair values and underexposed to assets trading below their true fair values.

If investors put more of their money in securities that are above fair value and less money in securities below fair value, they will get a lower return. It also means that the capitalization-weighted indices generate returns below what is possible. In a capitalization-weighted index, every stock that is overvalued is over weighted, while those that are undervalued are under weighted.

**Breaking Down Value**

Here's an example to help explain the performance of a capitalization-weighted index compared to, say, an equal-weight index. In an equal-weight index, it is even odds whether the overvalued stock will be over- or under-bought. Equal weighting under-weights every stock that is large, regardless of whether it's expensive, and over-weights each stock that is small, regardless of whether it's expensive.

Suppose there are only two stocks in the market and, according to CAPM, each has a true value of $1,000. One stock is estimated by the market to be worth $500, while for the other the market places a value of $1,500. The capitalization-weighted index would place 25% of the total portfolio in the undervalued stock and 75% of the total portfolio in the overvalued stock. The equal-weighted index requires that an investor place the same amount in each stock in his or her portfolio. In other words, each stock would comprise 50% of the portfolio regardless of whether it is overvalued or undervalued.

Five years later, the valuation errors are corrected and both stocks come to be valued at $1,000. In this case, if you had based your portfolio on a capitalization-weighted index, your return would be zero. On the other hand, an investor who placed her money in the equal-weighted index would experience a return of 33.5%. The lower-priced stock would earn $1,000 for the portfolio, while the higher-priced stock would lose $330 for the portfolio. The table below presents this example.

This is where fundamentally weighted indices offer an alternative. "Fundamental Indexation," a study released in 2005 by Rob Arnott, Jason Hsu and Phillip Moore, argued that fundamentally weighted indices outperformed the S&P 500, a traditional capitalization-weighted index, by approximately 2% per year for the 43 years of the study. The fundamental factors used in the study were book value, cash flow, revenue, sales, dividends and employment.

While 2% might seem small, when compounded it doubles the size of an investor's portfolio in 35 years. Clearly, this represents a better return compared to traditional capitalized-weighted returns. Keep in mind that studies show that many mutual funds underperform the overall market. Therefore, where investors place their long-term investments makes a real difference over the years, although this backtesting did not include the impact of fees and taxes.

**The Positive Side**

The argument for fundamentally weighted indices is that the price of a stock is not always the best estimate of the company's true underlying value. Prices can be influenced by speculators, momentum traders, hedge funds and institutions that buy and sell stocks for reasons that may not be related to the underlying fundamentals, such as for tax purposes. These influences can impact a stock's price for days or for years, making it difficult to create an investing strategy that can consistently produce superior returns.

The theory is that if a stock's price falls for reasons not related to its fundamentals, then it is likely, although not certain, that overweighting this stock will generate higher-than-average returns. Similarly, stocks with prices that rise more than their fundamentals would indicate overpriced stocks that are likely to underperform the market.

Like capitalization-weighted indices, fundamental indices do not require that an investor analyze the underlying securities. However, they must be rebalanced periodically by purchasing more shares of firms with prices that have fallen more than a fundamental metric, such as dividends paid, and selling shares in firms with prices that have risen more than the fundamental metric.

As more indices are created, investors will have new investment alternatives to match their investing needs and personal styles. Income investors might want to consider dividend-based indices, while growth investors might favor sectors that they believe will grow faster than the overall market.

**The Argument Against**

So what are the downsides to fundamentally weighted index investments? First, the cost to own funds based on fundamentally weighted indices can be higher than the capitalized-weighted indices. Because fundamentally weighted indices are still young, there isn't sufficient history to assess whether this increased expense will persist. Proponents of fundamentally weighted indices claim that they will experience higher turnover than capitalization-weighted indices due to the necessity to adjust the portfolio to match the fundamental factors. However, they have not yet achieved the cost efficiency of the large index funds. As a result, their expenses may be higher as a result of their smaller size. They must be rebalanced periodically by buying and selling shares to bring the fund into compliance with the index, and they will incur trading expenses similar to capitalized-weighted indices. Therefore, it is possible that the cost of fundamentally weighted index investments will fall as they achieve the size of capitalization-weighted indices.

The other criticism of fundamental indexing is that this new approach may not pass the test of time, as the market has a strong tendency to revert to the mean. This implies that no matter which approach an investor chooses, over time they may produce similar results.

Believers in fundamental indices point out that repeated research by Kenneth French from Dartmouth's Tuck School and the University of Chicago's Eugene Fama has shown that small cap and value stocks have outperformed other securities over most significant historical periods, and haven't yet displayed a reversion to the mean. This doesn't mean it won't happen; it just means there are opportunities to beat the market with fundamentally weighted indices if investors understand the risks. It seems that Benjamin Graham and his disciple, Warren Buffett, understood this concept years ago. Graham is quoted as saying, "In the short run, the market is a voting machine, but in the long run, it is a weighing machine."

As fundamentally weighted indices become more popular, there are a growing number of ways to invest through mutual funds and ETFs. Investors interested in funds based on fundamentally weighted indices should treat these investment opportunities like any other investment. They should perform the necessary analysis before committing their capital. Depending on one's personal situation, this includes understanding global and regional economies' performance, finding sectors that offer the best opportunity and assessing fundamentals that offer the best potential returns.

**The Bottom Line**

Finally, to believe that fundamentally weighted funds will outperform the S&P 500, the common benchmark, investors have to believe in two assumptions:

- Whatever causes valuation errors, which gave rise to the superior historical returns of fundamentally weighted indices, will continue into the future (value investing will not revert to the mean); and
- The market will recognize that overvalued stocks will eventually revert to the mean rather than remain overvalued.

If you believe that the market offers better opportunities to those who focus on value, growth or income, then investing in funds and ETFs based on fundamentally weighted indices may be a good alternative for you. They give investors the opportunity to invest in a blend of companies that are represented by an index that might outperform the overall market. Depending on the index, they may also incur more risk should the index underperform the market. Just like evaluating the fundamentals of a stock, investors need to do their homework by evaluating the index and the likely costs to be incurred. In any case, value, growth and income investors have viable investment alternatives to consider.