Fundamental index funds are not like other funds. Most index funds are capitalization weighted. That is, companies with a larger market capitalization take up a larger share of their portfolios.
Market capitalization is the number of shares outstanding times the price of those shares. This means that companies like Apple, that have a high share price and many shares, take up a bigger percentage of most index funds than stocks that are not yet so popular and have not already had huge gains in their stock prices. Cap-weighted portfolios tend to hold the current stars, not the future ones.
Fundamental index funds try to be different, and their differences have pros and cons. Their stocks are selected according to what they call fundamental valuations. Stocks are not selected on the basis of technical factors, which is a way of trying to predict price movement, or on the basis of membership in any of the traditional capitalization-weighted indexes like the Dow Jones Industrials or the S&P 500.
Their managers say they are not selecting value stocks, but in a way they seem to be. Fundamental index funds tend to be full of small-cap, cheaply priced stocks. That is, small cap companies and companies selling at low price-to-earnings and/or low price-to-book tend to dominate the holdings of the fundamental index funds. The selection criteria of these funds tend to eliminate popular growth stocks as well as fad stocks of all sorts.
Fundamental stock index funds try to find companies that represent solid value from an accounting point of view, which will theoretically be rewarded eventually by increases in the stock price. Fundamental index funds select stocks according to criteria believed to indicate true worth, such as valuations based on sales, cash low, book value, and dividends.
These are not presented as value stocks. Nevertheless, they are apparently selected for value rather than growth, as unpopular but sturdy stocks. This gives the funds a good chance to earn excellent returns when the worth of their holdings is recognized and growth in their under-priced stocks’ values follows.
Fundamental index funds should have a good chance after bubbles burst, when investors want solid reliable stocks. Fundamental criteria steer the index away from anything glitzy.
The selection criteria steer the funds away from stock picking too. They do follow an index, and so they have the well-known virtues of index funds. They are relatively low cost and low tax.
These funds, such as PRF, the Power Shares FTSE RAFI US 1000 Portfolio ETF, do appear to have slightly higher costs compared to cap-weighted index funds. The costs are due to higher fees, expense ratios, and turnover, but still run lower than those of most actively managed funds.
These funds eliminate certain stocks from consideration. Some stocks may not make good lifetime holdings, but can still bring sparkling returns for a while. High-flying growth stocks would not make the fundamental index fund cut.
A cynical investor might view these funds as value indexes by another name. Vanguard and many other advisors offer value indexes, and have for years.
Overall, fundamentally-based funds make sense for part of a stock portfolio. Designed to hold strong, smart companies, they hold value shares that offer safe and steady returns. Investors looking for good returns and possibly decreased risk may want to look into fundamental index funds.