The Fundamental Index® method selects and weights securities using fundamental metrics of company size rather than by capitalization to break the linkage between portfolio weight and any over- or under-valuation. In Fundamental Index® portfolios, pricing errors cancel eliminating the return drag observed in a cap-weighted portfolio.

Our research shows that any Fundamental Index® methodology performs better than a cap-weighted index. We tested a variety of measures, including sales, dividends, cash flow, book value, and number of employees. Some fundamental measures are more powerful than others, but the range is surprisingly narrow. The gap between the best and worst single-metric approach—a sales-weighted Fundamental Index® portfolio and a dividend-weighted Fundamental Index® portfolio—is barely 90 bps per year over the past 45 years. Sales is the wellspring from which profits, book value, and dividends must flow; so, it makes sense that sales work best and dividends work worst. But there is also a link with risk. A sales-weighted Fundamental Index® portfolio is the most volatile and works best in bull markets, while a dividend-weighted Fundamental Index® portfolio is the lowest volatility and works best in bear markets (while failing miserably in most bull markets).

The RAFI® (Research Affiliates Fundamental Index®) method uses four measures of size to gauge the economic footprint of a company:

• Cash Flow
• Sales
• Book Value
• Dividends

Our research recognized that any single measure of firm size has its own special vulnerabilities. For example, a dividend-weighted index will exclude well over half of all publicly traded companies, including many growth stocks and essentially all emerging growth companies. A sales-weighted index would clearly favor low margin companies over more profitable firms and so on. Multiple, equal-weighted metrics of company size results in a broader and more representative investment portfolio.

The Fundamental Index® methodology is explained in "Fundamental Indexation" by Arnott, Hsu, and Moore (2005) (PDF) and in our newsletter Fundamentals (PDF).

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