Fundamental indexes, like the ones created by Rob Arnott, chairman of Reseach Affiliates, are based on companies’ fundamental data, such as sales, book value, cash flow, dividends, and number of employees, while a company’s market cap is ignored. One way to look at fundamental indexing is as a bridge between passive and active investing. The fundamental metrics can be blended or used singly in the indexes. A variety of mutual funds and ETFs are based on fundamental indexes from Research Affiliates and Wisdom Tree.
Cap-weighted indexes are based on companies’ market capital. When companies in cap-weighted indexes are over-valued, they carry a heavier weighting in a cap-weighted index, leading to what Arnott calls a drag on return. The S&P 500, which celebrated its 50th anniversary in 2007, is the most prominent cap-weighted index.