The British are coming, the British are coming!

FTSE, the UK-based indexing giant, announced plans on July 18 to unveil a new suite of indexes that could revolutionize the U.S. indexing industry.  Working with Rob Arnott, chairman of Research Affiliates, FTSE said it would roll out two new indexes this Fall offering broad exposure to the U.S. and global equity markets. But rather than sorting those markets by the usual indexing methodology - based on market capitalization - the new indexes will rely on fundamental statistics, including sales, cash flow, book value and dividends.

"Cap weighted indexes overweight over-valued companies and underweight under-valued companies," said Arnott.  "We have done extensive research and have found that fundamental weighted indexes, on average, have outperformed the well-known cap weighted indexes in the US by some 200 basis points a year. In international applications, the benefit surpasses 300 basis points, on average."

Arnott's group put the academic muscle behind developing the indexes, while FTSE will lend its marketing muscle and handle the calculation of the indexes going forward.  Arnott's group has been managing similar fundamental indexes for private clients, some of whom heartily endorse the concept.

"CalPERS is intrigued by the concept of fundamental index construction and how this new approach may complement our traditional passive investments in market capitalization weighted benchmarks," said a spokesperson for the massive California public workers pension fund.  "We will be examining this innovative idea closely.",

It's safe to assume that FTSE will aggressively license the indexes, both for benchmarking and for investable products.

The two indexes due out this fall are the FTSE RAFI 1000 Index for the U.S. and the FTSE RAFI Global ex-U.S. 1000 Index; RAFI stands for Research Associates Fundamental Indexes. 

"Fundamental indexes are an exciting new development which will appeal to many investors," said Mark Makepeace, chief executive at FTSE Group, summing up his groups interest in the product.

But are they really a new development?  In many ways, these indexes share a lot in common with a number of "enhanced indexes" already on the market.  The Intellidex indexes from the American Stock Exchange, for instance, use fundamentals, valuation, timeliness and other risk factors to select stocks from the broader market that it expects will perform well over the coming months.  Like the Arnott products, the Intellidexes are designed to outperform the markets - and they have.  The broad market Intellidex index has outperformed the S&P 500 over the past ten years, returning 14.88 percent annually against 8.14 percent for the S&P 500.  These indexes form the basis of a family of ETFs from Powershares Capital Management.

In fact, some have gone further and wondered whether or not these products are truly "indexes," since they use subjective (if fixed and open) criteria to select stocks, and therefore they representation only a certain take on the marketplace.

Regardless of their true novelty, however, there's no doubt that the new products are interesting, and they certainly have folks talking.

"I think it's a very smart deal for both sides, because FTSE gives Arnott real indexing legitimacy while Arnott's academic research has been attracting all sorts of attention from the U.S. Plan Sponsor and institutional crowd that FTSE covets," said Jim Wiandt, editor of the Journal of Indexes.

As Arnott's research suggests, cap-weighted indexes do have their problems: They participate fully in every market bubble, and they potentially overweighting sectors and stocks that have done well in the past.  Arnott's research shows, for instance, the ten largest stocks in the S&P 500 at any given period have historically trailed the market by more than 26 percent over the subsequent ten-year period.

According to Arnott, the fundamental indexes have significantly outperformed their cap-weighted peers in both the U.S. and global markets.  In the U.S., for isntance, the RAFI 1000 has posted annualized returns of 12.47 percent since 1962, against 10.35 percent for the comparable cap-weighted index. Moreover, it did so with lower volatility (14.7 percent vs. 15.1 percent.)

The figure below shows the value added (in dark purple) of the fundamental index vs. the S&P 500.

The research also suggests that the index outperforms in both bull and bear market cycles, leading to "better" good years and "milder" bad years.

These products pave the way for other "fundamental indexes" in the future, and FTSE says more fundamental indexes are on the way.  The indexing giant did not comment on what form those indexes would take - whether they would look at an individual metric (say, just sales growth), or whether they would look at different individual countries (say, China). One intersting idea would be to examine other investing styles: While the current indexes focus around the general theme of value, a growth at a reasonable price index could make an interesting test case.