In recent years, investment companies have introduced a wave of fundamental index funds. Proponents claimed that fundamental ETFs and mutual funds would outdo the S&P 500 and other traditional benchmarks. Critics scoffed. But now many of the funds have significant track records, and the results are promising.

During the five years ending in December, PowerShares FTSE RAFI US 1000 (PRF) — the first fundamental ETF — returned 4.3 percent annually, outdoing the S&P 500 by 2 percentage points, according to Morningstar. Funds with winning 3-year records include PowerShares FTSE RAFI US 1500 Small-Mid (PRFZ), Schwab Fundamental US Large Company Index (SFLNX), and WisdomTree Emerging Markets Equity Income (DEM).

Investors have started to take notice. Among the ETF leaders are RevenueShares, which has $500 million in assets, and WisdomTree, with $10 billion in assets under management. More than $45 billion is in funds that track RAFI fundamental benchmarks, which were developed by Research Affiliates.

Junk Cap-Weighted Indexes?

Fundamental funds aim to correct flaws of traditional benchmarks. Proponents of fundamental funds say that benchmarks like the S&P 500 suffer because they are capitalization weighted. In that system stocks with the largest market values account for the most weight in the index. So Exxon Mobil, the biggest stock by market value, accounts for 3 percent of the S&P 500. Stocks in the smaller half of the index each account for less than 0.10 percent of assets.

As a stock comes into favor, its market value rises, and the hot shares come to account for a bigger percentage of the benchmark. During the bull market of the late 1990s, technology and growth stocks came to dominate the S&P 500. To match the benchmark, index funds had to sell unloved value stocks and shift assets to the market favorites. That proved to be the wrong move. When the Internet bubble burst, the S&P 500 funds collapsed. “It makes no sense to keep taking larger positions in overvalued stocks that are rising,” says Chris Brightman, director of strategy for Research Affiliates.

To correct the defects of traditional benchmarks, fundamental funds weight stocks according to measures such as earnings and dividend payments. RevenueShares puts the most assets in stocks with the greatest revenues. The biggest holding in RevenueShares Large Cap (RWL) is Wal-Mart Stores, which accounts for 4.5 percent of assets. WisdomTree LargeCap Dividend (DLN) puts 4.5 percent of assets in AT&T, the company that pays out the most total dividends.

The virtue of the fundamental system is that weightings do not necessarily become distorted during bull or bear markets. When stocks rise, fundamental funds may have to sell market favorites, rebalancing so that stocks are weighted according to dividends or other measures.

The Power of Rebalancing

To appreciate the importance of the rebalancing process, consider PowerShares FTSE RAFI US 1000. The fund weights stocks according to a composite of four measures: book value, sales, dividends and cash flow. In 2007, PowerShares had 18.7 percent of its assets in financials, compared to 17.6 percent for the S&P 500. Then in 2008, financial stocks collapsed and their weighting in the S&P 500 sank to 13.2 percent. The weighting in PowerShares actually rose to 20.1 percent. This occurred because the sales and book values of companies like JPMorgan and Bank of America remained enormous, even if the share prices had sunk.

Because PowerShares had a relatively heavy weighting in financials, the fund lost 40 percent in 2008, trailing the S&P 500 by 3 percentage points. But the story changed the next year. The RAFI benchmark rebalances in March, and that provided a crucial advantage when the market reached a bottom in March 2009. With stocks near the low, the fundamental funds rebalanced, buying more depressed financial shares so that the stocks would be weighted according to their fundamentals. As financials roared back, PowerShares gained 41.7 percent in 2009, compared to 26.5 percent for the S&P 500.

Another winner in the downturn was WisdomTree Emerging Markets Equity Income, which emphasizes stocks that pay out the most dividends. In 2008, the fund lost 34.5 percent, compared to a loss of 53.3 percent for the cap-weighted MSCI Emerging Markets index. The traditional benchmark was handicapped because it held big weightings of Chinese stocks that had sold for price-earnings multiples of more than 50. WisdomTree underweighted the high-flyers — and avoided the worst damage when the Chinese market sank. “During the rebalancing, we shifted away from stocks that had doubled,” says WisdomTree's research director Jeremy Schwartz.

A Proven Strategy?

Despite the early success of the fundamental funds, some financial advisors sound a note of caution. Because they steer away from the high-priced growth stocks that traditional benchmarks emphasize, the fundamental funds tend to have a value tilt, says Larry Swedroe, a principal of Buckingham Asset Management, a registered investment advisor in St. Louis. Swedroe says low-cost value ETFs can be sound holdings. Academic studies have shown that value stocks outperform over the long term, but investors should be aware of the risks, Swedroe says. Many value stocks are leveraged businesses with erratic earnings, precisely the kind of companies that sink in market downturns. “In the Depression, growth stocks far outperformed value,” he says.

Chris Brightman of Research Affiliates concedes that fundamental funds do have a value bias, but he argues that most of the recent success should be attributed to rebalancing. He points out that the RAFI 1000 benchmark outperformed, even though value stocks have lagged growth by a wide margin in the past five years.

Which funds should you try? Dividend ETF investors should consider WisdomTree Small Cap Dividend (DES), which has returned 3.7 percent annually during the past three years, outpacing the Russell 2000 Value index by more than a percentage point. The WisdomTree fund yields 3.6 percent, compared to a yield of 1.6 percent for the iShares Russell 2000 Value (IWN), which tracks a cap-weighted index.

Mutual fund investors can try Schwab Fundamental US Large Company (SFLNX), which has returned 0.7 percent annually during the past three years, outpacing the S&P 500 by 3.5 percentage points. By holding a small stake in such a fundamental fund, you can give a portfolio a bit of a value tilt and perhaps provide the kind of diversification that will cushion downturns and deliver decent results in bull markets.