By Scott Burns

What some call “Main Street indexing” appears to be gaining traction. Real results from actual funds have surpassed the returns of traditional market-capitalization weighted funds.

If you are a late arriver to this discussion, the basic idea comes from (and was patented by) Robert Arnott at Research Affiliates in Newport Beach. Rather than build an index fund in the traditional way, investing in stocks in direct proportion to their total market value, Arnott proportioned his indexes by weighting the stocks according to concrete measures such as profits, sales, and book value.

The result, he said in a 2004 paper, is an index that doesn’t force the fund managers to buy more shares of a high flying stock simply because its price has risen. Instead, the index only buys more shares in proportion to changes in its economic fundamentals.

As you might expect, John Bogle, the father of traditional indexing, disapproves. And William Bernstein, a much respected investment writer, has his doubts. In his view Arnott’s indexing method may simply be a method that captures a bit of the return-enhancing factors of size and lower price-to-book value. Research by Eugene Fama and Kenneth French has shown that two major factors influencing long-term investment returns are the market capitalization of the stock (smaller is better) and a low price-to-book value.

Today, we don’t have to talk about theories and back-testing.  We can now examine real results with real money in a fund available to small investors. One of Arnott’s fundamental index funds has been in operation since December 2005. It now has a 3-year track record with Morningstar and over $500 million in assets. If we compare results of five comparable funds for 2009 and the last 3 years we find that Arnott’s  Powershares exchange trade fund, the FTSE RAFI US 1000 fund (ticker: PRF), gained 41.74 percent in 2009 and lost at an annualized rate of 4.71 percent over the last three years. Both figures are better than the four indexes that can be considered competitors (see table below).

Main Street Indexing: So Far, So Good

This table compares the performance of five index funds that may be considered competitors. Although Research Associates doesn’t present their indices as “value” indexes, their large cap domestic index is classified as a large cap value fund by Morningstar. For that reason, both large blend and large value competitors have been presented.

Needless to say, three years of superior returns is far from conclusive. We’re likely to be reading articles about this for years, even decades. But a pragmatic view suggests that Mr. Arnott is very likely onto a good thing. Looking back a longer investing period by backtesting, Mr. Arnott’s firm found that their RAFI 1000 index provided an annualized return of 4.74 percent over the last 10 years while the S&P 500 lost 0.95 percent and the Russell 1000 lost 0.49 percent. Other fundamental indexes— such as domestic small cap stocks, emerging markets and developed markets also provided higher returns than conventional capitalization-weighted indexes.