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Is Fundamental Indexing All that It's Made Out to Be?

Our take on the theoretical basis behind this indexing approach.

It's been one of the toughest years on record for equity investors, and there aren't too many signs that things might settle down soon. Still, now may be a good time for investors to cautiously wade into stocks: Many veteran market observers agree that valuations haven't generally been this attractive in quite some time. And for many, a cheap index fund may just be the right ticket. After all, along with the great bargains available right now, there are a good many land mines as well, which makes active stock selection a nerve-wracking business. For those contemplating a sound index vehicle, now is also a good time to catch up with a continuing debate between the two main flavors of indexing: traditional, market-cap-weighted indexing versus fundamental indexing.

Weighting stocks in an index by their market caps has been the norm for decades, and (as most index purists continue to argue) for good reason. A market-cap-weighted index automatically rebalances itself because it fluctuates in perfect tandem with market prices of its component stocks, so it is easy and cheap to maintain. Also, the largest, most liquid stocks get the biggest billing, which further reduces transaction costs. Low-cost market exposure is among the most important selling points of passive investing, so those are powerful advantages.

But the new paradigm of fundamental indexing, formalized in recent years by prominent investing professionals and academics such as Robert Arnott and Jeremy Siegel, contends that it has a better approach. Essentially, fundamental indexing seeks to correct what it views as inefficiencies in traditional market-cap weighting. The prescription is to weight stocks not by their market values, but by their "fundamental" characteristics such as earnings, cash flows, and dividends.