'Godfather' of Fundamental Indexing Faces Challenge

The theory is that at any one point in time, a stock's price represents the best, unbiased estimate of its true value. Siegel countered that "a new paradigm claims that the prices of securities are not always the best estimate of the true underlying value."

This touched off a lot of sturm and drang in the indexing community. John Bogle, the founder of the (VFINXl Quote)Vanguard 500 (VFINX), the first index mutual fund, and Burton Malkiel, author of A Random Walk Down Wall Street, the book that brought the efficient-market theory to the masses, issued a stinging rebuttal. They said fundamental indexing wasn't a new paradigm but merely a more expensive index with a bias toward small-cap and value stocks.

But amid all this excitement, Arnott was noticeably silent.

Arnott literally wrote the book on fundamental indexing. In the March 2005 issue of the Financial Analysts Journal, he and two associates published a paper called "Fundamental Indexation." In it, he concluded that market portfolios constructed using metrics of company size other than cap-weighting outperformed the S&P 500 over a 43-year span by an average of 2 percentage points.

As chairman of Research Affiliates, an investment management firm in Pasadena, Calif., Arnott also realized he had a marketable investment strategy. He trademarked the name Fundamental Index and created the Research Affiliates Fundamental Index, or RAFI, based on four fundamental metrics: revenue, book value, free cash flow and gross dividends.