In 1976, Vanguard Group introduced a new kind of mutual fund, an index fund designed for retail investors. Vanguard Index 500 Fund sought to deliver the same returns as the S&P 500 benchmark.

The idea was revolutionary. Up till then, fund portfolio managers aimed to outperform the benchmarks by actively picking the best stocks and bonds. But Vanguard founder John Bogle argued that most active portfolios failed to match the benchmarks.

The active funds often produced disappointing results because managers picked the wrong stocks or imposed excessive fees that dragged down returns. Most investors would get better results by simply matching the market average, Bogle said.

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Over the years, Bogle’s idea became widely popular. While some index funds track the S&P 500, others mimic the performance of benchmarks that include bonds or foreign issues. Today, index funds account for about 20% of the $11.8 trillion in mutual funds.

Fundamental index funds

Now a challenger to Bogle’s invention has appeared. Known as fundamental index funds, the new breed aims to outdo the S&P 500 and other traditional benchmarks. Lately, many fundamental funds have been achieving their goals. A top performer is PowerShares FTSE RAFI 1000, a fundamental fund that holds large stocks.

During the past three years, the fundamental fund has returned 25.1% annually, surpassing the S&P 500 by six percentage points, according to fund tracker Morningstar.  Another winning fund is Schwab Fundamental US Small/Mid Company, which returned 31.4% annually during the past three years, topping the benchmark by eight percentage points.

Proponents of the fundamental approach claim that it excels because of flaws in the way that traditional funds structure their portfolios. Traditional S&P 500 funds invest in the stocks of 500 companies. Each holding is weighted according to the market value of the stock.

One of the biggest stocks in the S&P is Exxon Mobil. The total value of all the oil giant’s shares is $404 billion. Based on that figure, the company’s shares account for 3.4% of the assets in the S&P 500. So if you put $100 into an S&P fund, $3.40 will go into stock of the oil company.

Among the smallest stocks in the benchmark is Washington Post, which has a market value of $3 billion and accounts for 0.02% of the assets in the S&P 500. As a stock appreciates, it’s weighting in the S&P 500 can rise, while the weighting of unloved shares can decline.

The flaws in the system became clear during the bull market of the late 1990s when a handful of big technology stocks soared. As shares of Microsoft and Dell appreciated, they came to account for a big percentage of assets in the S&P 500.

As a result, investors who put cash into an index fund were keeping more of their assets in expensive technology stocks. When the technology stars collapsed in 2000, the index funds sank hard. The S&P 500 trailed funds that did not put so much weight on a few high-priced stocks.

Assessing holdings

To avoid emphasizing expensive stocks, fundamental funds weight holdings according to financial measures such as a company’s revenues, dividends, or earnings. According to advocates of fundamental benchmarks, indicators such as revenues can provide a consistent picture of a stock’s value that is not distorted by temporary swings in market moods.

As a result, fundamental funds do not put a big emphasis on a handful of expensive stocks. Consider RevenueShares Large Cap, a fundamental fund that puts the most weight on companies with the greatest sales. The fund has 1.1% of its assets in Apple. In contrast, the S&P 500 has 3.4% of its assets in Apple, a company with a highflying stock price.

Some of the most intriguing fundamental funds focus on dividends. A solid choice is WisdomTree Emerging Markets SmallCap Dividend, which has returned 33.5% annually during the past three years and outdid its average competitor by seven percentage points.

WisdomTree holds about 500 dividend-paying stocks. The companies that pay the most total dividends receive the greatest weight in the portfolio. WisdomTree offers investors a dividend yield of 3.7%. That is an attractive payout at a time when the stocks of the S&P 500 yield 2.0%, and money-market funds pay next to nothing.

Fundamental funds also offer a promising way to hold bonds. An intriguing choice is PowerShares Fundamental High Yield Corporate Bond Fund, which yields 5.6%. The fund weights bonds according to a variety of factors, including the sales and profits of an issuer.

Under the fundamental system, companies with more sales and profits have heavier weightings than issues with small sales and scant profits. In contrast, traditional bond index funds weight bonds according to the amount of debt that issuers have. So, a struggling borrower with huge amounts of debt will have a bigger weighting than a competitor with little debt and a pristine balance sheet.

Traditional bond index funds

To appreciate the problem of traditional bond index funds, consider Fidelity Spartan U.S. Bond Index, a fund that tracks the Barclays Capital U.S. Aggregate Bond Index, a popular benchmark. The traditional Barclays index includes a mix of government and corporate bonds.

But in recent years, the biggest issuer by far has been Uncle Sam. Struggling to finance mounting expenditures, the government has sold a flood of bonds. As Washington has become more indebted, its bonds have come to account for a bigger percentage of the benchmark. Now Treasuries account for 35% of the Barclays benchmark, up from 21% in 2002.

In recent years, Treasury bonds have held their value. But at some point, their prices could fall. That could punish conventional bond index funds and persuade investors to try the fundamental funds.