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.

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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