A more efficient market index?

Fundamental indexation has hit the investment community a year or two ago with real excitement and huge expectations. But thus far the performances of funds based on this methodology (securities are weighted according to their fundamental (economical) attributes instead of their market cap) have been mixed relative to the conventional indexation strategy.

John Spence of MarketWatch wrote the following story:

With a track record spanning about three years and including a brutal bear market, a new breed of index-based funds is showing mixed results, and the debate about them continues.

The backers of this new style of investing -- often called fundamental indexing -- contend that mutual funds and exchange-traded funds based on the Standard & Poor's 500-stock index , at the core of millions of small investors' portfolios, are flawed. The problem, they say, is that the S&P 500 can become top-heavy with pricey shares by using companies' market value as a way to weight stocks.

Their innovation: funds based on indexes that weight stocks by factors such as high dividend yields and low share-price-to-earnings ratios. They say these funds are less risky and offer a better chance for long-term outperformance.

So how have the ETFs that follow this approach fared?

PowerShares FTSE RAFI US 1000 Portfolio ETF averaged a negative return of 6.7% a year since its December 2005 launch through May 28, versus a negative 7.1%-a-year return for SPDR S&P 500 ETF for the period, according to Morningstar Inc.

For the past 12 months, it returned a negative 30.4%, versus a negative 32.8% for its S&P 500 rival.

WisdomTree LargeCap Dividend Fund has had a tougher time. From its June 2006 launch through May 28, it averaged a negative 9.9%-a-year return; the S&P 500 ETF lost 8.4% a year.

Rob Arnott, founder of Research Affiliates LLC, which created the index used by the PowerShares fund, says the market often values stocks incorrectly, so the goal "is to break the link between a stock's price and its weight." He favors weighting stocks by things like book value, cash flow, sales and dividends.

Research Affiliates readjusts its index annually, shifting the ETF more heavily into sectors where fundamentals are strong but stock prices have fallen. This has the practical effect of loading the index with "whatever stocks are most loathed" and lightening up on "whatever stocks are most beloved," so that investors can benefit "when market mood turns, as it always does," Arnott said.

The most recent rebalancing, in late March, boosted the PowerShares ETF's exposure to financial stocks to about 27% or so from 13% or so, said Jason Hsu, Research Affiliates' chief investment officer. The ETF benefited from the rally in financial stocks in April and May.

Because banks historically have been big dividend payers, the WisdomTree ETF's dividend-heavy focus exposed it to financial stocks during the worst of last year's financial crisis. Even so, the ETF bested the S&P 500 ETF for calendar year 2008, down 35% versus 36.7%.

"Investors need to keep their eye on long-term performance" of at least three years, said Luciano Siracusano, chief investment strategist at WisdomTree Investments Inc. .

In general, WisdomTree's earnings-focused ETFs have fared better than its dividend-weighted ones over the past two years, Siracusano said.

The firm's international dividend ETFs also have performed better, mainly because more international companies pay dividends, so there is a bigger subset from which to choose, he says. To accommodate investors in the U.S. who don't want to bet heavily on the financial sector, the firm recently restructured two of its 34 dividend ETFs to exclude financial shares, he said.

At Vanguard Group Inc., which decades ago pioneered indexed investing for the masses based on the S&P 500, Chief Investment Officer Gus Sauter remains a skeptic of the new methodology. He said it gives a tilt to "value" investing, the hunt for shares that are undervalued.

"My view is that fundamental indexing is a triumph of marketing," he said. "It's a midcap value fund dressed up as something different."

Fundamentals-based indexing beat the S&P 500 during the bear market of 1973 and 1974, and after the dot-com bust of 2000-02, Sauter noted, but not during the tech-stock rally of the late 1990s.

Hsu and WisdomTree President Bruce Lavine say fundamental-indexing strategies aren't designed to outperform in speculative markets. They perform well in other environments, however, especially after bubbles burst, Hsu added.

As measured by money under management, the revolutionaries trail. The PowerShares ETF had about $434 million recently, and the WisdomTree LargeCap Dividend had about $350 million -- compared with more than $60 billion in the S&P 500 ETF