A Fund Designed to Grow

Disappointed with the significant flaws he (correctly) sees in major indexes, Roger Arnott has developed an alternative. His PowerShares FTSE RAFI US 1000 (NYSE: PRF) index ETF, based on fundamental analysis, is well worth a look -- but it may not be quite what you expect.

What's wrong with the old indexes?
You may not realize it, but the revered "Dow" includes just 30 stocks. And while the market-cap-weighted S&P 500 averages its components' market value, the Dow simply represents an average of its holdings' prices. So a $100 stock rising $5 -- a 5% gain -- will make a much bigger difference than a $15 stock that rises $0.75 -- even though that's also a 5% jump.

Even the S&P 500 is problematic. Its top 25 holdings make up far more than a third of the index's value. That leaves the remaining 475 companies to make up less than two-thirds, and as you can imagine, the smallest 400 or so really don't have much influence on the index.

In contrast, Arnott's index features companies that have been weighted according to fundamental values, such as sales, cash flow, book value and dividends. Arnott says his backtesting shows that such indexes have outperformed market-cap-weighted indexes by about two percentage points domestically, and three points internationally. Indeed, the new index lost only 2.4% annually, on average, over the past four years, versus a 3.6% annual loss for the SPDR S&P 500-tracker.

Big differences, little differences
That may not seem like much, but small point differences can make a huge difference in the long run. If you invested $10,000 for 25 years and earned an annual average of 9%, your holdings would grow to $86,000. But if that nest egg grew at 10%, you'd end up with more than $108,000 -- a 25% increase!

Oddly, though, when you look at the fund's top holdings, they're currently not radically different from the S&P 500's. Check out both indexes' top 10s:

Data: Morningstar.

The new index's relatively strong performance owes partly to its past or present top holdings, which aren't or wouldn't have been among the S&P 500's top components. These include Avis Budget Group and Ford (NYSE: F), which were up 1,774% and 337% respectively in 2009. Their favorable fundamental characteristics earned them a spot in Arnott's index, even though their share prices took a big hit as fewer people bought or rented cars.

Right now, the new index's top lineup might look less exciting than the S&P 500's; the latter sports Apple, with its iPhone- and iPad-fueled growth, and IBM, which rose more than 20% in the last year partly on its high-margin push into software. But these companies may be due for breathers, while the RAFI 1000 index is more heavily weighted in beaten-down-but-promising financial institutions such as Bank of America, Citigroup, and Wells Fargo. Innovative conglomerate General Electric also gets much more love from the RAFI 1000, partly thanks to price-to-book and price-to-cash-flow ratios that are much lower than the S&P 500's averages.

The new fundamental index isn't a no-brainer investment, At less than five years, its track record's on the slim side. But the RAFI 1000's still worth checking out, and it's a good reminder that seeking fundamental value can help you outperform the market.

Plenty of other exciting indexing strategies can also help you beat the market.