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Andrew Hallam is the index investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

Rob Arnott was excited to introduce one of his heroes, John Bogle, to what he hoped would be a better index fund. He called it the Fundamental Index. But Bogle, the Vanguard Group's founder, said its higher costs would hurt investment returns. Burton Malkiel, author of A Random Walk Down Wall Street, also shared his doubts. He joins Larry Swedroe, author of The Incredible Shrinking Alpha, who says that Mr. Arnott's creation is a marketing success that may not beat the market. That's a tough trio of detractors.

But 10 years after creating it, Mr. Arnott's RAFI Fundamental Index is performing just as he said it would. Measured in U.S. dollars, it averaged 9.4 per cent from December, 2005 to Dec. 31, 2014. That compares with a 7.9-per-cent return for the S&P 500.

A traditional index is cap-weighted. So it puts its greatest weighting in stocks that are largest. Even a traditional small-cap index fund is most influenced by the largest stocks within the small-cap index it tracks.

Fundamental indexes are different. An index weighted fundamentally would ignore each company's market capitalization. Instead of the largest stocks having the greatest effect on the index's level, the most profitable companies would. Profitability, in this case, isn't determined by how far share prices have recently risen. Instead, it refers to the business's actual earnings, book values and dividends.

In a cap-weighted index, popular overpriced stocks often make up the biggest weighting. Think of Nortel Networks Corp. in the late 1990s. The company's share price soared. But as a business, Nortel wasn't earning profits. When the stock crashed, traditional index fund investors got burned.

If a Canadian Fundamental index had existed, it would have dramatically reduced its exposure to Nortel as the stock soared. "We contra-trade against fads, bubbles and crashes," Mr. Arnott says, "saving investors the pain of a round-trip: Riding a stock up to a lofty weight as it becomes a darling of the markets, and then back down to Earth, as happens far more often than not."

In an interview with the research firm Morningstar, Mr. Bogle called the strategy "witchcraft." He says it's too much like active investing. But Mr. Arnott says it isn't based on forecasting specific stock directions or future business earnings.

Researchers, Mr. Arnott, Jason Hsu, and John West reported in their book, The Fundamental Index (Wiley, 2008) that from 1962 to 2007, the S&P 500 averaged 10.3 per cent a year, compared to a back-tested result of 12.3 per cent for a fundamental index containing the same stocks, but in different proportions. Compounded over a 45-year period, such a difference with $10,000 invested would exceed $1-million. It would grow to $823,944 at 10.3 per cent versus $1,848,647 at 12.3 per cent.

In a back-tested 23-country study between 1984 and 2007, fundamental indexes would have beaten the market in 22 countries. Only Switzerland proved an exception.

But back-tests mean little, early critics said. Many added that investors would have seen market-beating results had they tilted towards value stocks. "But those critics have some explaining to do," says Mr. Arnott. "We've now got a decade of outperformance, in the U.S., outside the U.S., in large and small companies. And value has been outperformed by growth over the last decade in all of these domains!"

While fundamental indexes beat their cap-weighted counterparts over the past 10 years, fighting the growth stock advantage over the past five years was a bigger challenge. The iShares Canadian Fundamental Index ETF (CRQ-T) averaged 7.64 per cent ending Feb. 28, 2015. The iShares S&P/TSX Composite Index ETF (XIC-T) beat it, averaging 8.37 per cent per year.

The iShares U.S. Fundamental Index ETF (CLU.C-T), however, didn't disappoint. It averaged 19.18 per cent, throttling the 15.51 per cent earned by the iShares Core S&P 500 Index ETF (XSP-T).

But results were mixed, in the international equity category. The iShares International Fundamental Index ETF (CIE-T) earned 9.85 per cent. It beat the cap-weighted iShares MSCI EAFE Index ETF (CAD-Hedged) (XIN-T), which averaged 9.72 per cent. But TD's cap-weighted e-Series International Index Fund beat both, averaging 11.19 per cent.

The iShares Japan Fundamental Index ETF (CAD-Hedged) (CJP-T) won a round for Mr. Arnott's creation, averaging 10.86 per cent. Its only cap-weighted competitor was TD's e-Series Japanese Index Fund, which averaged 9.68 per cent.

Finally, iShares MSCI Emerging Markets Index ETF (XEM-T) scored for cap-weighted indexes, averaging 5.9 per cent versus 4.41 per cent for the iShares Emerging Markets Fundamental Index ETF (CWO-T).

Overall results are mixed. So we won't know which would have won, a portfolio built with fundamental or cap-weighted indexes over the past five years. Much would have hinged on how the funds were allocated. But Mr. Arnott's 10-year tests have favoured fundamental indexes – just as his research said it would.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 28/05/24 3:52pm EDT.

SymbolName% changeLast
Enterprise Group Inc
Morningstar Inc
Ishares MSCI Emerging Markets ETF
Ishares Core S&P TSX Capped Comp ETF
Ishares MSCI EAFE Index ETF
Ishares Core S&P 500 ETF CAD Hdg ETF

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