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.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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