"Fundamental Indexing" has made waves in the investment management community over the past year and a half, with assets invested climbing from $100 million at the end of 2004 to about $4 billion today. Even its critics -- notably Vanguard founder Jack Bogle and Princeton economist Burt Malkiel -- concede it's getting results in terms of returns. But, they argue, capitalization-weighted indices still make more sense in the big picture.

Who's right?

For Rob Arnott and his associates at Research Affiliates, Fundamental Indexing means you might be able to exploit the market's zero-sum game after all. Billed as a way to escape the perils of over- and under-valuation in the stock market, it works by weighting investment picks not according to market capitalization, but by any one of a number of "fundamental" indicators of size -- such as book value, sales, or even number of employees

Any method that determines weighting by size -- independent of market valuation -- will bring markedly better results, said Arnott. Cap-weighting "has a structural inherent flaw that pulls its returns down," he said in an interview with the MFWire.

Previous versions of the concept went nowhere because they missed a key element: selecting companies on a fundamental basis, as well as weighting them that way. "If you omit the first part of that, you have a growth bias," he explained.

But in a growth-dominated market, cap-weighted indices prevail, as Arnott admits. This is one of a number of cautions and criticisms leveled at the Fundamental Indexing posse by Bogle and Malkiel in a June 27 Wall Street Journal op-ed entitled, Turn on a Paradigm?. The authors also pointed out that fundamentally weighted indices charge higher management fees associated with frequent realignments, put investors at risk of greater capital gains liability, and may already have "arbitraged away" excess returns.

Most of all, however, Bogle and Malkiel took issue with the idea that fundamental indexing is a "new paradigm" for the index sphere. "There's no question that Rob's fundamental indexing has worked very, very well over the last five years," Malkiel told the MFWire. "My difference with Rob is the question of why it works."

While Arnott believes the markets are inefficient, Malkiel went on, Arnott's methods involve two factor tilts: "the tilt towards smallness and the tilt towards quote, value, unquote ... the style tilts have a way of reverting to the mean, and I worry a lot that they're not going to work as well in future."

In the present market, with its compressed price-earnings multiples, the difference between growth and value stocks is minimized, he said: "That's the kind of market where this sort of technique will work extremely well." Asked whether the pro-fundamental effect could be described as cyclical, however, Malkiel responded, "It can work for thirty years ... so I don't want to call it cyclical, but I don't want to call it permanent."

While some have charged that his indexing mode is a kind of active management, Arnott points out that in growth periods, fundamentally-weighted indices still trail cap-weighted indices by less than active value managers. And in contrast to the notion that he's taking a narrow view of investment and return patterns, Arnott sees fundamental indexing as the product of thinking in broadest terms.

"The market is cap-weighted, so if you want to own the market you have to be cap-weighted. But if you want to own the economy, it's a cleaner way to do that."  

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