Fundamental Index Funds Look Promising

NEW YORK (TheStreet) -- With much fanfare, fundamental index funds began appearing in 2006.

Proponents predicted that the new funds would outdo the S&P 500 and other traditional benchmarks. Have the fundamental funds lived up to the hype? It is too soon to draw final conclusions, but the early results look promising. Some fundamental funds have outdone the S&P 500 and other traditional benchmarks.

In many cases the margins of victory have been small. But the results are noteworthy because many of the fundamental funds emphasize value stocks -- a segment of the market that has been out of favor in recent years. When value stocks return to the forefront, the fundamental funds could surge.

Among the winners is PowerShares FTSE RAFI US 1000 (PRF), a large-cap fundamental ETF that returned 0.44% annually during the past five years, according to Morningstar.

In comparison, Vanguard 500 Index (VFINX), the granddaddy of S&P 500 mutual funds, lost 0.37% annually. Fundamental funds also excelled in small-cap categories. During the past three years, Schwab Fundamental US Small/Mid Company (SFSNX) returned 18.10% annually, compared to 14.7% for Vanguard Small Cap Index (VSCIX), a traditional index mutual fund.

Proponents of fundamental funds say that traditional benchmarks are inferior because they are weighted by market capitalization. Under the traditional system, stocks with big market values account for a larger percentage of assets. In the S&P 500, the stock with the largest market value is Exxon Mobil (XOM), which accounts for 3.5% of the assets in the index. Among the smallest holdings is Washington Post (WPO), which accounts for 0.02% of the benchmark.

As a stock appreciates, its weighting in the cap-weighted index can rise, while the weighting of unloved shares can decline. Critics say that cap weighting can depress returns because it requires investors to put more money into expensive stocks. The flaws in the approach were highlighted in the late 1990s when a handful of technology stocks soared and came to account for a big percentage of the S&P 500. When the technology stars collapsed, the index sank hard.

To avoid emphasizing expensive stocks, fundamental funds weight holdings according to financial measures such as a company's sales, dividends, or earnings. Some fundamental funds rank stocks according to one measure, while others use a combination of several indicators.

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