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Fundamental Index Funds Look Promising

RevenueShares Large Cap (RWL) puts the most weight on companies with the greatest sales. The top holding is Wal-Mart Stores (WMT), which accounts for 4.55% of assets. According to advocates of fundamental indexes, indicators such as revenues can provide a consistent picture of a stock's value that is not distorted by temporary swings in market moods.

While cap-weighted benchmarks tend to overweight hot growth stocks, fundamental funds tilt toward value shares and stocks with smaller market capitalizations. In the S&P 500, Apple (AAPL) is among the hottest stocks, and the company is currently the benchmark's second largest holding with a weight of 2.58% of assets. In the fundamental RAFI US 1000 benchmark, Apple ranks as the 22nd largest holding, accounting for 0.67% of assets.

Critics argue that the fundamental funds represent a kind of active management, which places a bet on value shares and stocks with smaller market caps. There is nothing wrong with emphasizing value stocks, the critics say. But investors can accomplish the same thing by holding funds such as the Vanguard Value Index (VIVAX), a cap-weighted fund that holds large-cap value stocks.

The critics have a point, but the returns suggest that fundamental funds are not simply clones of value benchmarks. During the past five years, Vanguard Value Index lost 2.5% annually, underperforming the S&P 500 by a big margin. So you might expect that fundamental funds would have lagged too. But that did not happen.

What explains the success of the fundamental funds during a period when value was out of favor? The fundamental funds rebalance their holdings in a way that boosts returns, says Robert Arnott, chairman of Research Affiliates, the developer of the RAFI fundamental benchmarks.

Say a stock accounts for 2% of the assets of a fundamental fund. The company's revenues remain steady, but the shares suddenly soar and account for 3% of assets. The fundamental fund will have to rebalance, selling the hot shares until the weighting returns to the original level. As a result, the fundamental fund must sell expensive shares and buy undervalued ones. That formula could produce solid long-term returns.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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