The basic premise of the The Fundamental Index: A Better Way to Invest is that an efficiency weighted portfolio has and will over the long run outperform a market cap weighted portfolio. The underlying assumption is that the efficient market hypothesis does not hold true, and thus it is possible for errors in equity share prices to occur and this will lead to errors in stock weights for traditional market cap indexes.
The Fundamental Index combines 4 constructs--a company's sales, cash flow, book value, and dividends--to weight companies in an overall index. Companies that do not pay dividends are not penalized in the index and are weighted based on the other 3 elements. The ultimate goal is to build an index that reflects a company's economic footprint rather than its market cap. During periods where mis-pricing in markets has been most egregious, such as the Dot-Com Bubble, high growth companies attain heavy weighting in a market cap index. Conversely, the Fundamental Index rebalances weightings based on the 4 constructs mentioned; therefore, it avoids overweighting companies whose fundamentals have not yet caught up to its valuation.
The Fundamental Index: A Better Way to Invest
is a must read. The idea is fairly simple, yet revolutionary in an investing world which has so heavily depended on market cap weighted indexes. However, the most impressive part of the book is not the idea itself but the empirical evidence presented by the authors, Rob Arnott, Jason Hsu, and John West. The authors go to great lengths to present historical performance for the Fundamental Index in a wide variety of global markets, in a variety of bull and bear markets, over several decades. The evidence is compelling; in addition, they make the case that we are entering an era of lower returns (an impressive argument when you consider the book was published in early 2008 prior to Lehman) and they show that the Index has historically performed well in such an environment.
The Fundamental Index: A Better Way to Invest is published by Wiley and is currently available on Amazon for less than $20 - a steal when you consider the content may change the way you invest.