Fundamental indexing has become the latest style of investing with exchange traded funds (ETFs), and many who prefer this type of weighting feel that the traditionalists are flawed.

Fundamental indexers believe that the mutual funds and ETFs based upon the S&P 500 are flawed, despite the fact that they represent the core of millions of portfolios. The chief criticism is that traditional indexes are too top-heavy with the most expensive shares. In other words, by weighting the index based upon market capitalization, the index is too top heavy with the largest market players, explains John Spence for The Wall Street Journal.

Fundamental indexing is an index based upon stocks that weight by factors such as high dividend yields and low share-price-to-earnings ratios. These companies are viewed as less risky because they offer better long-term performance possibility.

Many analysts think that the market tends to value stocks incorrectly, so the fundamental approach was created to simply break the relationship between the stock’s price and its weight in the index, and instead take other factors into consideration.

Providers such as PowerShares and WisdomTree value this approach to indexing, as it allows the stocks that normally would not be included in an index to get a chance, then prove itself when the market turns. Stocks are weighted by factors such as book value, cash flow, sales and dividends.

Whatever method of indexing you prefer, don’t forget to watch the trend lines, too. While understanding the construction of ETF you’re investing in is very important, take a look at what’s moving, too. If something has crossed its trend line, and you feel that it’s right for you, consider getting in.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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