Fundamental indices

main article: Alternative Indices

Fundamental indices, developed by Research Affiliates and calculated by FTSE, are known as Research Affiliates Fundamental Index (RAFI). RAFI indices are passively managed market cap indices that use a security weighting system that ranks stocks according to four fundamental value factors. Fundamental indices occupy the Passive security selection/ Fundamental security weighting segnent of the Index Strategy Box (Fig.1).



RAFI indices have also been developed for the bond market, and are calculated in conjunction with Ryan ALM, Inc.

History
Fundamental indexing was developed by Robert Arnott and associates at Research Affiliates, who developed the index security selection and weighting methodologies and researched historical back-tested performance. In 2005, they partnered with index provider FTSE to begin calculating a growing suite of RAFI indices, both for US and international stock markets. The following table shows the historical introduction of RAFI indices.

Research Affiliates was granted a patent on the RAFI methodology on November 18, 2009

In 2010 Research Affiliates laid the methodology groundwork for constructing fundamental bond indices in a paper published in the Journal of Portfolio Management. . On February 10, 2010 Research Affiliates partnered with Ryan ALM, Inc. to construct and calculate a series of RAFI US bond indices.

Characteristics
Fundamental Indexing is the subject of considerable debate among both investment professionals and individual investors.

Security Selection and Weighting
The construction of a RAFI index begins with the selection of a company universe (for example the FTSE All US All Cap Index, or the FTSE Developed ex US Index) and a screening process that ranks the companies according to four fundamental valuation factors: sales, cash flow, book value, and dividends (see table below). The selection and weighting process is described in detail in the quote box, RAFI Index Construction Rules.

Rebalancing and Turnover
In order to preserve proper weighting of companies, fundamental indices are rebalanced once a year. The result is that fundamental indices have higher turnover than do comparable asset class market capitalization indices. In terms of implementation, ETF manager Powershares has managed its RAFI funds with much less turnover than mutual fund manager Schwab.

Returns
The following tables provide investment returns for two broad-based US RAFI indices that have index tracking funds. Given the value tilt of the RAFI index construction, the return series of comparable Russell market and value indexes is provided for comparison.

The following tables provide investment returns for two broad-based International RAFI indices that have index tracking funds. Given the value tilt of the RAFI index construction, the return series of comparable Russell market and value indexes is provided for comparison.

Investment Options
RAFI Index funds are available from Charles Schwab (mutual funds) and Powershares ( as ETFs). PIMCO offers four institutional enhanced RAFI index funds.

Fundamental Index Methodologies

 * FTSE RAFI Index Series
 * FTSE RAFI Index Series Methodology Overview

Forum Discussions
Caveat: Comparing fundamental to traditional capitalization weighted ("cap-weighted")  benchmark index funds is a subject of constant debate. The following forum threads provide insight:
 * Fundamental Indexing
 * 'Fundamental Indexing' by Arnott
 * Fundamentalists at the Gates: The Trouble With Cap-Weighted
 * Is Fundamental Indexing superior to Cap Weighted indexing?

Please ask in the forum if you are unsure about investing in a product.

Articles

 * Rob Arnott, Gus Sauter, Jeremy Siegel, Fundamental Indexing Smackdown, JOI, September/October 2007
 * William Bernstein, Fundamental Indexing and the Three-Factor Model, Efficient Frontier, May, 2006
 * John C. Bogle and Burton G. Malkiel, Turn on a Paradigm?, June 27, 2006
 * Rich White, Market Cap, Equal Weight And Fundamental Indexing, Investopedia
 * Wikipedia Fundamentally based indexes

Academic Papers

 * Arnott, Robert D., Hsu, Jason C. and Moore, Philip, Fundamental Indexation. Available at SSRN: http://ssrn.com/abstract=604842
 * Arnott, Robert D., Hsu, Jason C., Li, Feifei and Shepherd, Shane D., Applying Valuation-Indifferent Indexing to Fixed Income (September 4, 2008). Available at SSRN: http://ssrn.com/abstract=1263246
 * Blitz, David and Swinkels, Laurens A. P., Fundamental Indexation: An Active Value Strategy in Disguise (July 1, 2008). Available at SSRN: http://ssrn.com/abstract=1184848
 * Dopfel, Fred, The Arithmetic of Fundamental Indexing, Investment Insights, 6.07. June 2007, Volume 10, Issue 3, Barclays Global Investors
 * Estrada, Javier, Fundamental Indexation and International Diversification (December 2006). Available at SSRN: http://ssrn.com/abstract=949162
 * Hsu, Jason C. and Campollo, Carmen, An Examination of Fundamental Indexation (November 2005). Available at SSRN: http://ssrn.com/abstract=843384
 * Kaplan, Paul D.,Why Fundamental Indexation Might—or Might Not—Work FAJ, Volume 64, No.1, 2008 CFA Institute
 * Perold, Andre, F. Fundamentally Flawed Indexing FAJ, Volume 63, No.6, 2007 CFA Institute
 * Pope, Brad, Insights On Market Capitalization And Fundamental-Weighted Indexes Barclays Global Inevestors
 * Treynor, Jack, Why Market-Valuation-Indifferent Indexing Works, Financial Analysts Journal Volume 61 • Number 5 ©2005, CFA Institute