If we dig into the results and understand the attribution, I am quite pleased with how they held up on a global basis.  In the US markets, fundamental index portfolios underperformed in 2007 and 2008, but did well in 2005 and 2006.  The US market has been savage to value stocks recently.  Normally, in a bear market, stocks with a foundation of profitability (based on metrics such as book value, cash flow and dividends) hold up well. But this bear market has been very different in that regard.

When you adjust for the relative performance of the value stocks, the results for fundamental index portfolios are quite striking.  At the start of 2008, when measured using trailing five-year earnings (to smooth out fluctuations in the business cycle), the FTSE-RAFI® US 1000 index was priced at a 12 percent discount to cap-weighted indices.  This discount widened to 24 percent at the end of 2008. If relative valuation multiples drop by 12 percent, you would expect to have experienced 12 percent underperformance, no?  But the underperformance was only three percent. 

On a global basis, the fundamental indices underperformed in 2008 by a scant 60 basis points.  Absent the US, 2007 and 2008 were both successful years for the fundamental index concept … as were the previous seven years.  Over the past three years, during which time these indexes have been live and published, fundamental index portfolios added 180 basis points per annum globally, compared to cap-weighted indices.

In the US, the S&P 500 has won two years in row.  But, on a global basis, in any year there will be outliers. In 2008, the US was an outlier.  Growth dominated the US market and value was savaged.  The Fundamental Index concept held up surprisingly well under those circumstances.

Never in my career have I seen a new idea gain so much traction so fast.  Market-cap weighted indexing took about two decades to achieve $20 billion in assets.  Fundamental Index strategies crossed that threshold a year ago, less than three years after I wrote the first article on the topic.   We garnered nearly $10 billion in new assignments during 2008.  The growth has been quite remarkable.

Even so, fundamental index portfolios are is not yet a large factor in the capital markets.  Post-crash, roughly $20 billion in assets are invested in fundamentally weighted index portfolios, including the various “me too” strategies.  Out of the $30 trillion invested in the capital markets, this is a drop in the bucket.

What I find most surprising is the stridency of the opposition.  Our new ideas have evoked a visceral reaction, which I find amusing.  Why is there such antipathy?  Perhaps others are competitively threatened by it.  I don’t know. 

I believe the fundamental index concept is an an interesting way to invest.  Whether you call it an index or a strategy, it is undeniably an interesting idea.  It’s hardly anything to get upset about!  It is gaining traction, although it is not a large factor in the markets yet, by any stretch of the imagination.

I find this aspect of the debate interesting.  It is mere semantics.  It hinges on the definition of our terms.  If you define an index as in the dictionary - a metric for measurement or for comparison - there is no problem calling it an index. 

If you think an index should be historically replicable, formulaic, liquid, scaleable and objective, then, by that definition, we have an index on all counts.  But most classic indices, including the S&P 500, don’t qualify.  [Ed. Note: The composition of the S&P 500 is not objective; it is decided by a committee.]

But if you define an index as mirroring the composition of the market, then capitalization weighting is necessary.  It would be deceptive to say any fundamental index portfolio does that.

This issue of semantics is not new.  Price- and equal-weighted indices have been around for a very long time.  And yet, this is the first time anyone has raised the issue that a non-capitalization-weighted index is not an index.  Why were the Dow and Value Line indices not singled out or criticized on this basis?  [Ed. Note:  The Dow is price-weighted and the Value Line is equal-weighted.]

I believe the underlying controversy is not due to semantics; it is a reaction to a perceived threat, by much of the indexing community.  They had a good ride for the last 50 years, with no competition except from other cap-weighted indexers.  Someone else came up with a good alternative approach which attracted adherents.  I think it’s not the use of the word “index” that troubles them!