Quick! Name a stock market index.
Odds are you said either Dow Jones Industrial Average (INDEX: ^DJI) or S&P 500 (INDEX: ^GSPC). They are the overwhelmingly popular ways to track and invest in the broad U.S. stock market.
But they are both flawed indexes -- particularly from an investment standpoint. The S&P 500 weights each of its 500 components by market capitalization, with the biggest companies holding the largest share of the index. That can create skews that work against investors, weighting holdings toward the market's most overvalued companies. This was especially true a decade ago during the dot-com boom: Microsoft (NASDAQ: MSFT) and Cisco (NASDAQ: CSCO) were two of the S&P's largest holdings and two of the most overvalued companies on the planet.
But as popular as the S&P 500 is, it's not the only way to index. One form growing in popularity is called "fundamental indexing," where components are weighted by their economic footprint -- things like revenue, earnings, and dividends.
Last week I sat down with Robert Arnott, CEO of Research Affiliates and a pioneer of fundamental indexing. I asked him to explain the concept and why it works. Here's what he had to say (transcript follows):
Morgan Housel: What is the broad idea behind the fundamental index?
Robert Arnott: The fundamental index re-examines the way we construct our indexes. Indexes have classically been constructed not as a strategy, but as a way of measuring market performance. That was the original intent. If you want to measure market performance, you must cap weight because the market is cap-weighted.
Now that doesn't mean you have to invest that way. If you invest on a cap-weighted basis, then the more expensive a company is, the bigger your allocation to it, the higher its valuation multiple, the bigger your exposure. That means that you're going to be predominantly focused on growth stocks, on popular companies, on safe havens, on trendy companies with great stories attached to them. That's a wonderful way to invest for a very skinny risk premium. You don't get a big risk premium by investing in popularity or safety.
If you look at the broad macro economy, the macro economy isn't cap weighted; it's weighted in accordance with the economic footprint of a company's business. It could be measured by sales or profits or book value or dividends or number of employees, and the list goes on and on. It turns out that if you weight your portfolio by any of these objective measures of a company's economic footprint, historically, you get about a 2% higher return.
Where does that come from? Part of it comes from the fact that you have a structural value tilt. If the market is paying a big premium for growth and discounting value stocks, and you're reweighting those companies back to their economic footprint, you're taking the growth stocks down and the value of stocks up. You're creating a value tilt. The value tilt is part of the return, but the big part of the return is that you're contra-trading against the market's biggest bets, and you're contra-trading against the market's constantly changing views.
The market does pay a premium for growth, but it's constantly changing its mind on what premium or discount a company deserves and which companies deserve that premium or that discount. And so, by contra-trading against the market's most extreme views, those extreme views are sometimes wrong. And because companies at high multiples sometimes deserve it and sometimes don't, contra-trading means that if it doesn't deserve the high multiple, you're profiting from not having peak exposure in a company at a peak price.
So fundamental index simply weights companies according to their economic footprint. Works all over the world. The idea has gone from nothing to about $75 billion in the space of seven years. It's gaining traction, it's getting recognition, it's getting credibility and respect. It used to be viewed as an off-the-wall idea, kind of like cold fusion. Now it's seen as a legitimate, sound idea -- a sensible way to invest.
Fool contributor Morgan Housel has no positions in the stocks mentioned above. The Motley Fool owns shares of Microsoft. Motley Fool newsletter services recommend Cisco Systems and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.