Disclosure: I work for a company that provides Fundamental Index® mutual funds in the Canadian marketplace.
The S&P/TSX Composite Index, the S&P 500 index and other major benchmark indexes around the world are “market capitalization weighted”. This means that the weight of any constituent stock is determined by its market capitalization versus the total market capitalization of all stocks in the index. For example, if an index had a total market cap of $100 billion and stock A had a market cap of $5 billion, Stock A would have a 5% weighting in that index.
A Fundamental Index uses fundamental factors to determine weightings, specifically the FTSE RAFI series uses free cash flow, book value, gross dividends and total sales. Note that these are not ratios (like price-to-book), these are price indifferent metrics. In other words, a Fundamental Index weights companies using fundamental factors to determine weightings in its index.
As long as:
1. There are mispricings in the market (stocks get overpriced and underpriced)
2. Active managers exist and serve to eventually identify these mispricings and therefore bring them closer to fair values (they buy underpriced companies, they sell overpriced companies)
then a Fundamental Index will outperform a market cap weighted index over longer periods of time.
This is because a cap weighted portfolio will assign more and more weight to a stock as it gets overpriced. Therefore once it is identified by the market as too expensive, more of your portfolio will decrease. Vice versa, as a stock is beaten up, a cap weighted portfolio will assign less and less weight to that stock. Once the market has identified this and brings the price back up a cap weighted portfolio is underexposed to this stock which is increasing in value.
This manifests into a long term outperformance of a Fundamental Index versus a cap weighted index.
There are other considerations: a Fundamental Index will have slightly higher turnover, and slightly higher costs. But personally, I am not invested in any cap-weighted index funds if there is a Fundamental Index fund alternative.