Fundamental Index Funds: Great Players, Wrong Game

Several years ago a group of investing heavyweights, led by Robert Arnott of Research Affiliates and Jeremy Siegel of WisdomTree, claimed to have built a better index fund.

Ever since, these "fundamental indexers" have waged a public debate with Vanguard founder Jack Bogle and other passive-investing purists over what an index fund is.

That argument distracts from the true advantages of fundamental index funds. Like traditional indexes, fundamental indexing calls for owning most of the stocks in the market, instead of picking individual issues. But rather than holding shares in proportion to a company's total market value, the new funds weight them based on attributes such as earnings, dividends, or valuations.

As a result, their portfolios tilt toward value stocks, or shares that are cheap relative to profits or assets.

"And all the evidence we have seen is that there is a value premium" -- that is, an extra return for value stocks -- says Paul Kaplan of the fund research group Morningstar.

They also skew to smaller stocks, which likewise outperform over long periods. (Says who? Eugene Fama, for one; he just won the Nobel in economics.)

Purists cry foul. "Anytime you depart from the market, you're an active manager," says Bogle.

Here's the thing, though: Even if you think this is another form of active stock picking, it turns out fundamental funds may be the best possible way to do that. Arnott now argues that "we're more of a threat to active management than to cap-weighted indexing, because investors are more likely to be deeply disappointed with their active managers."

For example, PowerShares FTSE RAFI U.S. 1000 ETF , which tracks Arnott's strategy, gained an annualized 18.7% over five years, beating the S&P 500 and 91% of all active large-cap funds. Similarly, WisdomTree Earnings 500 and WisdomTree SmallCap Earnings beat more than 60% and 90% of their respective active peers.

How? In addition to their tilts, these funds enjoy a cost edge. WisdomTree Earnings 500 charges 0.28% of assets, a percentage point less than the average active fund. It also trades infrequently, cutting transaction costs.

So if you want to dabble in active funds for a shot at outperformance, consider using a fundamental fund instead.

A portfolio half in an S&P 500 indexer and half in an average active large-cap fund would have returned 15% annualized over the past five years. Had that active stake been in the PowerShares fund, you'd have earned about two points better a year. That's a fundamentally sound result.