The top twenty companies in a market- cap weighted index and in a fundamentally weighted index probably wouldn’t differ much because they are huge companies, both in terms of market cap, sales, and earnings. So GE, Wal-Mart, and Microsoft would be still there, but will have different rankings. Accumulated over time, these differences become huge and lead to the outperformance of the fundamental indexes™.

Q: It seems that the performance of the fundamentally weighted indices would be much smoother than that of the market-cap weighted ones because the fundamentals are less volatile than the price. Is that correct?

A: I agree; the performance is much smoother. For example, in the period 1990 through 1998, the fundamental approach outperformed the market-cap approach. Since mid-1998 to 2000, the market took off due to the huge growth of the Internet stocks, so the market-cap approach outperformed the fundamental approach. The outperformance for those 18 months offset the entire 8 years of outperformance of the fundamental approach.

So, yes, the FTSE RAFI indices have smoother performance over the long term, missing certain growth spurts in the short term. But by 2000, the fundamental index has not only caught up, but was already far outperforming the market-cap indices because of the crash on the market. So, I believe that for long-term investors, the fundamental approach holds up.

Q: What annual turnover do you anticipate in the fundamentally calculated FTSE RAFI indexes, compared to the turnover in the market-cap weighted indexes?

A: The turnover of the fundamental indexes ™ is about 10% to 11%, which is higher than the turnover of the marketcap weighted indexes at 6% to 7%. The higher turnover is mostly due to the earnings volatility of the smaller companies. However, even if you factor in the extra cost for the turnover, the higher rates of return far exceed the slightly higher transaction cost that you incur for the turnover. So it doesn’t lead to a material change in the returns that we get on index.

There are no expenses calculated in those numbers, but the trading costs are nominal nowadays. Also, FTSE starts with a liquidity screen before we apply any fundamental factors, so we make sure that even the small companies in the index trade frequently enough and are investable.

Q: Who are the main users of the fundamentally weighted indices? Are you receiving a lot of interest from the large pension funds that seek core long-term investment strategies?

A: Yes, it has been very successful. We are starting to see more traction and interest at the retail investor level. Retail investors have already put several billion USD in the Charles Schwab Fundamental Index™ funds that were launched this past April and based on the FTSE RAFI index series. It was the retail market and the smaller institutions that showed more willingness to accept this approach initially. The large plan sponsors are typically slower to react, but now we are starting to see momentum and interest from very large funds.