Index funds have gained popularity on the wings of the idea that, since you can't beat the market, cost is the only difference that matters. Accept this, and you're left with little room for competitive maneuvering -- but Rob Arnott and his associates at Research Affiliates, LLC have mounted a significant challenge to the received archetype.

"I think this is important work," Arnott told the MFWire in a recent interview. Since the first S&P index in 1957, he noted, people have said that a cap-weighted index will overvalue some stocks and undervalue others -- but they've called this a useless observation, since there is no way of identifying which is which.

"They got it half right: you don't know, but it's not a useless observation," he said.

"Fundamental Indexing," a concept developed and propounded by Arnott and others -- including Jason Hsu and Phil Moore -- refers to a way of weighting an index's stock picks not according to their market capitalization, but by any one of a number of "fundamental" indicators of size, such as book value or sales. The idea -- as Arnott explained in a 2005 issue of the Financial Analysts Journal, which he edits -- is to untangle the size and valuation factors that together determine a company's capitalization. An index impervious to market valuation will generally reel in more reliable returns, he argues.

"The logic behind it, the reason why it works, is so intuitive," he said.

Arnott and the others began experimenting with numbers several years ago. They found that weighting indices according to sales would have added 200 basis points to domestic markets over forty years. Moving on to other factors, they uncovered similar effects when determining weights by companies' profits, dividends, and even by number of employees. The impact held when applying the method to international markets -- with up to 600 basis points added in emerging markets, Arnott said. Across markets, sectors, and company sizes, the move to Fundamental Indexing consistently added value.

Such showy results were bound to get the attention of entrepreneurial types, who had probably abandoned hope of stealing clients from low-cost index big guns like Vanguard. Indeed, start-ups like WisdomTree (which weights indices by dividends, a characteristic Arnott actually found improved returns the least) may be best positioned to focus on and exploit the benefits of Fundamental Indexing.

But Research Affiliates wants something back for all its work. After going public with their research in 2004, the company partnered with FTSE Group to launch the FTSE RAFI index series of 24 indices in late 2005. They've also partnered with PIMCO to launch a bond version, said Arnott, as well as with companies in Japan and Scandinavia to make products available there.

Others want to run with the idea sans a partnership, and while he declined to name them, Arnott said he believes "we'll probably reach terms" with these parties. He doesn't expect a decision on a patent application until next year, but argues that after providing a means of adding 200 basis points, it's not much for Research Affiliates to look for "a little bit of profit." A precedent set in State Street Bank & Trust Co. v. Signature Financial Group -- a late '90s case in which State Street was successfully sued over use of an investment structure developed for Signature, detailed in an article from The Entrepreneur Network -- looks in Arnott's favor on this count.

Arnott does believe he's hit on an idea worth spreading. "I think it's going to catch on in a huge way," he admitted. With about $4 billion currently invested in fundamentally weighted indices, up from $100 million at the end of 2004, he said a 10 percent market share 10 years from now would not surprise him.

Not everyone, however, is unreservedly enthusiastic about this prospect. Next week: the debate over Fundamental Indexing.  

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