When fundamental index funds began appearing in 2006, proponents had high hopes. Rob Arnott, chairman of Research Affiliates, said that fundamental indexing represented a better mousetrap, a system for outperforming the S&P 500 and other standard benchmarks. How have the funds done so far? While it is too soon to make final judgments, the early results are promising. Many funds have performed as Arnott hoped, surpassing competitors by wide margins.

Among the top performers is Schwab Fundamental U.S. Small Mid Company Index ( SFSNX), which tracks a RAFI benchmark, an index designed by Research Affiliates. During the past three years, the Schwab fund has returned 1.7% annually, outdoing the Russell 2000 small-cap benchmark by 4 percentage points. Other RAFI funds with strong records include Schwab Fundamental U.S. Large Company ( SFLNX) and Schwab Fundamental International Large Company ( SFNNX).

Investors have taken notice of the strong performance of fundamental funds, and assets have poured in during the past year. Now funds based on RAFI benchmarks hold $4 billion in retail assets and $38 billion in institutional money. Other sizable players include WisdomTree, with $8 billion in assets, and RevenueShares, with $500 million.

Arnott says that fundamental benchmarks excel because they weight stocks in the portfolios according to measures such as revenues and book values. Since Wal-Mart Stores ( WMT) has the most revenue of any company, it is the largest holding in RevenueShares Large Cap ( RWL), a fundamental fund. In contrast, conventional benchmarks, such as the S&P 500, weight holdings based on market capitalizations. So ExxonMobil ( XOM), the biggest stock in the S&P 500, accounts for 3.1% of the benchmark's assets, while the smallest members of the index are only responsible for 0.01%.

Arnott says that the system of market-cap weighting is flawed because it sometimes emphasizes a handful of giant stocks. That occurred in the late 1990s when technology stocks skyrocketed. As the share prices of Cisco Systems ( CSCO) and Intel ( INTC) climbed, a few technology stocks came to account for a big percentage of the S&P 500. To match the benchmark, portfolio managers of S&P index funds had to sell shares of low-priced stocks and shift the cash to the technology giants. When the Internet bubble burst, technology shares collapsed, and the S&P 500 fell sharply.

Fundamental benchmarks are less prone to suffer from booms and busts because the revenue and book value figures don't bounce around much from year to year. Companies with the greatest revenues and book values tend to hold their leadership positions. As a result, the portfolios of fundamental funds are relatively steady. That can result in better long-term returns.

To appreciate why the fundamental funds shined in recent years, consider how the S&P 500 and Schwab U.S. Large Company Fund differed during the downturn. As the credit crisis unfolded, financial stocks collapsed. In the S&P 500, the financial weighting dropped from 17% of assets in 2007 to 10% in the spring of 2009. But revenues of financial companies such as JPMorgan ( JPM) and Bank of America ( BAC) were still enormous. As a result, the weighting of financial stocks in the Schwab fundamental fund held steady at about 20%.

In 2008, the decreasing financial holdings helped to protect the S&P, which lost 37% for the year, and outpaced the Schwab fund by 3 percentage points. But when financials roared back in 2009, Schwab shifted into the lead, gaining 42% for the year, and outdoing the S&P by 16 percentage points.

For this year, Schwab has returned 10.6% and outpaced the S&P by 3 percentage points as the recovery of financial stocks continues. "Fundamental funds tend to do best when markets are volatile and share prices move away from the fundamental values," says Jason Hsu, chief investment officer of Research Affiliates.

Part of the appeal of many fundamental funds is that they have a bias for value stocks, which tend to outperform the market over the long term. Consider RevenueShares Large Cap, which weights stocks solely on revenues. Holdings in the fund's top 10 include Ford Motor ( F) and Citigroup ( C), companies with big revenues and relatively modest market capitalizations.

In its top 10, the fundamental fund has no computer or software stocks. In contrast, the top 10 holdings of the S&P 500 include technology blue chips, such as Apple ( AAPL), which has a big market capitalization and relatively small revenues. "The weightings of the top 10 holdings in the S&P 500 are based on the speculation and hope of investors," says Sean O'Hara, president of RevenueShares. "We base our weightings on the reality of revenues."

A Better Mousetrap

In recent years, these fundamental index funds have outdone the traditional benchmarks.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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