Instead of focusing on size, these ETFs weight stocks by key measures such as profits or sales. We pick four standouts. By Nellie S. Huang, Senior Associate Editor From Kiplinger's Personal Finance, January 2014 Although every investor wants to beat the market, few are able to do it consistently. But what if, over time, you could beat the broad market with something as simple as an index fund? See Also: Top Performing Mutual Funds by Category Some exchange-traded funds—members of a new class of ETFs—have done just that. They are called fundamental-index funds because they focus on companies’ financial results, such as sales or earnings, not just their size. PowerShares FTSE RAFI US 1000 ETF (symbol PRF), for example, leans toward large U.S. firms with strong balance sheets. Over the past five years, it has returned 18.8% annualized, beating SPDR S&P 500 ETF (SPY), a traditional index ETF that tracks Standard & Poor’s 500-stock index, by an average of 3.6 percentage points per year (all returns are through November 1). Eager to jump in? Not so fast. These newfangled designer index funds offer fresh, sometimes compelling strategies, but they are not magic. For starters, their strategies can take ten years or more to play out. Plus, each index is unique, so it’s important to understand how they are built and any extraordinary risks they pose before you incorporate one into your portfolio. Advertisement What are fundamental-index funds? Instead of weighting stocks by market capitalization, the way traditional indexes do, fundamental indexes use measures that are tied to a company’s financial picture, such as earnings or dividends, to name a few. A few of these funds are a decade old—among them, iShares Select Dividend (DVY), which sifts stocks for those with high dividend yields and ranks them by their yield. But many are much newer. Of the nearly 220 fundamentally oriented ETFs, nearly half have been around for five years or more. Nevertheless, investors are buying. The funds now hold more than $1 trillion in total assets. The draw: Over the long haul, fundamental-index funds will beat the market. At least, that’s what the firms behind these funds will tell you, based on extensive back-testing that pitted many of the new indexes against the best-known market-cap-weighted benchmarks, such as the S&P and Russell indexes. “Fundamental indexes have outpaced by two percentage points per year” over long periods, says Chris Brightman, of Research Affiliates, a Newport Beach, Cal., pioneer in fundamental indexes. But back-testing is one thing. How have these ETFs performed in real life? The answer is mixed. Among those with a five-year record (more than 80 funds), half beat the typical fund in their respective category and the other half lagged. Advertisement From its launch in December 2006 through November 2013, PowerShares Fundamental Pure Small Core (PXSC) has lagged the small-company Russell 2000 index. The fund has tracked two different fundamentally oriented indexes. From inception through June 2011, PXSC tracked an Intellidex index that considers factors such as a stock’s price relative to its 52-week high, cash flow, book value, and share buybacks, among others. Over that time, the fund lost an annualized 1.6%, lagging the Russell 2000 by an average of 2.9 percentage points per year. In mid-2011, the fund adopted a RAFI fundamental index that focuses on sales, dividends, cash flow and book value. But the change has not helped much: The fund has continued to lag; from the time the switch was made through November 29, it trailed the Russell 2000 by an average of 1.5 percentage points per year. The bottom line: Not all fundamental indexes shine. And although some are better than others, the higher returns may come with more risk. Many of these funds plunged more than the overall market in 2008, for instance, though they rebounded strongly in 2009. That combination suggests that some fundamental-index funds are more volatile than their vanilla rivals. PowerShares FTSE RAFI US 1000, for instance, lost 40.0% in 2008—3.0 percentage points more than the S&P 500 lost—and ranked among the bottom 10% of all ETFs that focus on large, undervalued companies. But in 2009 it beat its benchmark by a staggering 15.2 percentage points, with a 41.7% return. Over the past five years, the FTSE RAFI US 1000 ETF has been 22% more volatile than the S&P 500 and funds that track it. Time—as in decades—will tell whether enhanced index funds are better than funds weighted by market capitalization. But for now it’s safe to say that fundamental-index funds are just different. “It’s all salad, just a different dressing,” says Rick Ferri, founder of Portfolio Solutions, a Troy, Mich., investment firm that uses index funds and ETFs. How do they work? Advertisement Some funds home in on a single factor, such as revenues, earnings or dividends, and use it to drive stock selection and weighting in the index. In WisdomTree’s profits-focused index funds, such as SmallCap Earnings (EES), a firm’s profits count for more than its market value in determining its rank in the fund. WisdomTree’s dividend-focused funds, on the other hand, put the emphasis on—you guessed it—dividends. And in the ETFs from RevenueShares, only sales count. Others focus on a combination of measures. RAFI indexes, created by Research Affiliates, weight firms by sales, dividends, cash flow and book value (assets minus liabilities). First Trust employs three value-oriented and three growth-oriented factors to create its AlphaDex indexes, including return on assets on the value side and sales growth on the growth side. Another key difference between these index funds and their traditional counterparts: regular rebalancing. Some fundamental-index funds do it quarterly (RevenueShares); others do it once a year (some WisdomTree and iShares funds, for example). Market-cap-weighted index funds, by contrast, are never rebalanced. All the extra work required is one reason fundamental-index funds cost more. They charge an average of 0.55% in annual fees—more than the typical charge of 0.48% for traditional index funds. Should I invest in a fundamental index? Advertisement Don’t replace all of your traditional index funds with fundamental-index products. Instead, use them to further diversify your portfolio. Some advisers who use funds suggest that clients split their index money 50-50 between traditional and fundamental-index funds (on top of any assets you may have in actively managed funds). Anthony Davidow, an asset allocation strategist at Schwab, prefers a 60%-40% mix of fundamental and traditional index funds. Which fundamental-index funds are worth investing in? We favor funds with easy-to-understand strategies, five-year track records that beat the appropriate benchmark on a risk-adjusted basis, and at least $150 million in assets. Here are our favorites. RevenueShares Large Cap (RWL). It’s simple, and it works. This fund ranks the companies in the S&P 500 by annual revenues over the previous 12 months. Firms with the highest revenues get top billing. RWL has outpaced the S&P 500 over the past five years by an average of 2.4 percentage points per year. What’s more, the fund has been only slightly more volatile than the S&P 500. WisdomTree MidCap Earnings (EZM). Annual earnings determine the ranking in this fund. Over the past five years, its 23.2% annualized return beat iShares Russell Mid-Cap ETF (IWR) by an average of 3.8 percentage points per year. Wisdomtree International SmallCap Dividend (DLS) has been a bit less volatile than SPDR S&P International Small Cap ETF (GWX). But the WisdomTree fund has outpaced GWX over the past five years by an average of 1.7 percentage points per year. And WisdomTree Emerging Markets SmallCap Dividend (DGS) has been less volatile than SPDR S&P Emerging Markets Small Cap ETF (EWX), yet it has beaten the SPDR ETF by an average of 1.7 points per year over the past five years.