NEW YORK ( TheStreet ) -- The RevenueShares family of ETFs has been on a roll.Top performers include RevenueShares Large Cap ( RWL). During the past five years, the fund returned 9.2% annually, compared to 7.8% for the S&P 500, according to Morningstar. RevenueShares Small Cap ( RWJ) returned 13.6% annually, compared to 8.3% for the Russell 2000 small-cap index. The ETF company has achieved those stellar results by relying on a simple methodology that focuses on revenue. To assemble the large-cap portfolio, RevenueShares starts with the 500 stocks of the S&P 500. Then the company weights the stocks according to their sales. If a company accounts for 2% of the revenue in the S&P 500, then the stock will have 2% of the assets in the ETF. In contrast, the S&P 500 and most other standard benchmarks weight holdings according to the market values of the stocks. For RevenueShares Large Cap, the biggest holding is Wal-Mart ( WMT), which accounts for 4.2% of assets. The giant retailer only accounts for 0.85% of the assets in the S&P 500. The RevenueShares ETFs are among the most successful funds that follow fundamental approaches. Those weight stocks according to fundamental measures such as revenue, dividends or earnings. Introduced by Research Affiliates in 2005, fundamental strategies now account for $100 billion in assets invested in institutional and retail funds. Successful fundamental ETFs include PowerShares FTSE RAFI 1000 ( PRF) and WisdomTree Total Dividend ( DTD). Proponents say fundamental funds can perform so well because they overcome the flaws of market-cap-weighted benchmarks. To appreciate why, consider how the weighting of the S&P 500 shifted during the late 1990s bull market. At the time, prices of big technology stocks were soaring. As that happened, companies including Cisco Systems ( CSCO) and Intel ( INTC) came to account for an increasing percentage of assets in the index. When the Internet bubble burst in 2000, the S&P 500 fell hard as technology stocks sank. Fundamental benchmarks avoid such steep collapses because they don't overweight the hottest stocks. Since measures such as revenue are fairly steady, the stock allocations of fundamental benchmarks tend to avoid sudden shifts.
The advantages of the revenue weighting became clear last year when shares of Apple ( AAPL) soared. By the time the stock peaked, the iPhone maker accounted for more than 4% of the assets of the S&P 500. But the stock only was 1.1% of the assets in RevenueShares Large Cap. When Apple plunged, the downturn hurt the S&P 500 but had relatively little impact on the fundamental fund. RevenueShares Large Cap has a pronounced tilt toward unloved value stocks. That occurs because the benchmark emphasizes low-priced stocks with hefty revenue, including Chevron ( CVX) and Ford ( F). In contrast, the S&P 500 gives big weightings to some hot growth names. The top 10 holdings of the S&P 500 include technology giants such as Google ( GOOG). Not surprisingly, RevenueShares Large Cap does well when value stocks are in favor. But the fund has outperformed market-cap weighted value funds. The extra juice comes because RevenueShares rebalances each quarter. To appreciate why this improves returns, consider a stock that accounts for 1% of the assets in the fundamental fund. Say shares rise and account for 1.5%. When the rebalancing occurs at the end of the quarter, the fund portfolio managers will have to sell some of the hot shares so the stock maintains its target weighting. Say the stock dips and the weighting drops to 0.8% of assets. Then the fund would have to buy more of the depressed shares at the rebalancing. As a result, the system requires the portfolio managers to constantly sell expensive stocks and buy cheap ones. That can be a sound investing policy. In contrast, the S&P 500 follows the opposite approach, buying expensive stocks as they rise and selling unloved issues as they drop. Should you dump your market-cap index funds and shift to RevenueShares and other fundamental competitors? Not necessarily, says David Koenig, an investment strategist for Russell Investments, which operates fundamental and market-cap benchmarks. Koenig argues that investors can increase their diversification by holding both fundamental and market-cap funds. Market-cap benchmarks can excel in roaring bull markets, while fundamental portfolios do better at other times. Some financial advisers have been urging clients to keep half of their passive assets in fundamental indexes and half in market-cap weighted. "By combining the two strategies, you can get a more balanced exposure," Koenig says. Follow @StanLuxenberg This article was written by an independent contributor, separate from TheStreet's regular news coverage.