The great debate has raged on for years. Nature versus Nurture? No. Evolution versus Intelligent Design? Certainly not. Coke versus Pepsi? Getting warmer.

The great debate I'm speaking of is "market capitalization versus fundamental measures", what the best way to weight a stock index? I thought it would be interesting to look at a real-world version of the debate, and so in this article we'll do just that.

What's all the fuss?
Market-cap-weighted indexes have been with us since the beginning of time, or at least since the S&P 500 arrived in 1957 during the dawn of Markowitz-inspired Modern Portfolio Theory (MPT). The S&P 500 is a pretty simple proxy for the market. You can benchmark against it or invest passively in it through an index fund or, more recently, an ETF. Market-cap indexes and passive vehicles that track them now come in all flavors from style-based value or growth, to large or small cap and everything in between.

Then a new idea came into currency: investors seeking passive market returns would do better with something other than market-cap weighting. That "something" could be sales, or dividends, or cash flow or some other fundamental measure.

The argument is that a stock price at any point in time reflects the stock's true intrinsic value plus a random error, or "noise". Thus stocks can be overvalued or undervalued and that price error affects their weightings in a market-cap index.

So, if you are invested in a market cap vehicle, then at any given time you will have some holdings whose weights are higher than their fundamental value merits and vice versa. Over time, as price converges towards true value, you would expect the overweight dogs to underperform and the underweight stars to shine.

The premise of fundamental indexing is to sever the link between price error and weighting by substituting one or more fundamental measures.

When is an Index Not an Index?
That is all well and good. Fundamental index supporters come armed with backtested data to support their position. However, we wanted to see a real live version, which brings us to PowerShares FTSE US 1000 (NYSE: PRF) an ETF offered by PowerShares, that tracks the fundamental-weighted FTSE/RAFI 1000. While, iShares TR Russell 1000 (PSE: IWB) is a Barclays iShares ETF that tracks the Russell 1000; a market-weighted index.

The following table shows the performance of the fundamental index PRF versus its market-cap peer IWB for the period (annualized) since the launch of PRF at the end of 2005.

ETF Return Risk
PRF FTSE/RAFI 1000 20.19% 5.49%
IWB Russell 1000 17.66% 6.39%

Source: Zephyr & Associates LLC StyleAdvisor
Returns are annualized by total return (appreciation plus dividends)
Risk is annualized by standard deviation
Time period: January 1, 2006 - May 31, 2007

That looks pretty good. In comparing two differently weighted indexes, each consisting of 1,000 large companies, the fundamental alternative delivered an annualized 61 basis points (bps) of additional value, moreover with a lower risk measure. The FTSE/RAFI 1000 uses sales, cash flow, dividends and book value as the weight measures.

However, there are a couple caveats. First, a fundamental index is not completely passive. In order to maintain the fundamental weights the index has to rebalance periodically (once a year in the case of the FTSE/RAFI 1000). Market cap indexes by definition rebalance automatically. This comes with a cost.

In fact, the expense ratio - the annual deduction of fees and expenses - of PRF is 76 basis points compared to 15 basis points for IWB. That's a significant cost to the investor, albeit implicit.

One criticism of fundamental index strategies is that they are just value strategies in disguise who tend to hold names with lower value multiples than market cap indexes. For the sake of comparison we added another ETF, the iShares Russell 1000 Value (PSE: IWD), (which has an expense ratio 20 bps), to the mix for the same time period and got the following result:

ETF Return Risk
PRF FTSE/RAFI 1000 20.19% 5.49%
IWB Russell 1000 17.66% 6.39%
IWD Russell 1000 Value 22.05% 5.98%

Source: Zephyr & Associates LLC StyleAdvisor
Returns are annualized by total return (appreciation plus dividends)
Risk is annualized by standard deviation
Time period: January 1, 2006 - May 31, 2007

The purpose of a passive index strategy is to find the most cost-efficient way to invest in the market over a long period of time without much effort. Does a fundamental index approach make sense? It's too early to tell. Backtesting is a useful reference point but that's about all. To make economic sense on a net-of-fees basis PRF would have to deliver some 60 bps of value over its market cap counterpart year in and year out.

2006 was generally a good year for value stocks and you could have captured the benefits of a pure value play with the relatively inexpensive IWD. For now, the jury is out.

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