A few months ago there was a stir in the financial press on the introduction of “fundamental indices.â€? The claim was that index funds that are weighted based on company fundamentals, dividends, free cash flow, book value, etc., outperformed standard capitalization weighted indices. David Jackson at ETF Investor did a good job in covering the many issues raised by this research. (Please note the links to earlier articles on fundamental indices.)

Now Research Affiliates and FTSE have introduced a series of fundamental indices that cover the global markets, the FTSE RAFI Index Series. This includes an international index, the already existing US index, and 22 national indices. All of the indices have shown in historical testing to outperform their capitalization-weighted counterpart.

Although PIMCO has introduced two mutual funds based on the concept, it is not altogether clear whether this concept will take off. A case can be made that a global fundamental index would be better constructed than one based on market capitalization. In the 1980s when Japan’s stock market went vertical it dominated the MSCI EAFE index. A fundamental index could have avoided the distortions of this bubble.

The academic and investment communities have a long-standing investment in capitalization-weighted indices. This is due in part to the theoretical considerations and ease of management. It will take some time to see if capitalization weighted indices are able to achieve inroads in the investment marketplace. If fundamental indices do take off it will be due to their (realized) superior performance.

Fundamental indices are by construction, biased toward value and small caps. It is not news that the past few years have seen value and small cap outperform. The backers of fundamental indices had better hope that these trends continue while they attempt to get their investment products off the ground.