New fundamentally-weighted indexes have become more popular within the exchange traded fund (ETF) industry. One such index is the Research Affiliates Fundamental Index (RAFI), which is tracked by the PowerShares FTSE RAFI US 1000 (PRF). RAFI is one of the more popular fundamentally-weighted indexes that has outperformed the S&P 500 the last one-, three- and five-year periods, says Russell Bailyn of Russell Bailyn’s Financial Planning Blog.

The RAFI was created by Robert Arnott, chairman of Research Affiliates, who has argued against market-cap weighted indexes since at least 2004 when he released an academic paper outlining its benefits. Fundamentally-weighted indexes weight companies by factors such as sales, cash flow, book value and dividends. In an article by John Spence of MarketWatch, Arnott says that using market-weighted indexes can be especially harmful during bubble periods because they expose investors to overvalued companies. Take for instance the dot.com bubble burst. Technology companies dominated common indexes, such as the S&P 500, until the bubble popped. Because fundamental indexes are still so new, we’ll have to wait and see what their track record produces.

Tags: Dividend ETFs