Fundamentalism is on the rise in the exchange traded fund (ETF) world. A flurry of new ETFs is offering a different way to gain exposure to stock markets.

The vehicles eschew the traditional basis of most stock market ETFs – indices such as the S&P 500 that reflect shifts in share prices and market capitalisation. Instead they are based on indices of stocks centred on so-called fundamental factors, such as earnings, dividends and the book value of companies.

Born out of disillusionment with the flaws of market cap indices, the fundamental ETFs have quickly generated interest. Assets under management in this segment are still relatively small compared with the overall $573.9bn in ETFs. But they have made an impressive start for a new investment product class that only really emerged in the past 18 months.

The indices the ETFs use are backed by influential market thinkers. Rob Arnott’s Research Affiliates is behind the RAFI indices that underlie the Powershares FTSE RAFI products, which have $1bn of assets. Powershares’ rival WisdomTree is supported by Jeremy Siegel, Wharton School professor and author of Stocks for the Long Run. WisdomTree has some $1.5bn in assets under management in fundamental ETFs.

And leading players have won support from influential market thinkers. PowerShares Capital Management, an Amvescap subsidiary which has $1bn under management in its fundamental ETFs, has been backed by Mr Arnott, the editor of the Financial Analysts Journal.

The main investment case for fundamental ETFs is that they aspire to avoid distortions and pricing anomalies arising out of market cap indices.

“Market cap-weight indexes depend on the efficient market hypothesis, which claims that the market price of a security is the best estimate of its true underlying value,” says Jonathan Steinberg, chief executive of WisdomTree.

“The theory states that if markets are efficient, market cap-weighted indexes offer the highest potential return for any given level of risk …but the efficient market theory is just that – a theory. Our research indicates that stocks are not always priced efficiently.”

Mr Arnott says the problem is that market cap indices overweight all overpriced stocks and underweight all underpriced stocks. “How likely is it that the top 10 [stocks] in market cap and the top 10 in true fair value will be the same stocks?” he asks. “Some of the top market cap stocks get there by pricing error. None get there as a consequence of being undervalued.”

For example, when the dotcom bubble was at its peak, market cap indices had a large exposure to overpriced stocks that were shortly due to crash. Mr Arnott says backtesting of a composite of the RAFI indices showed an excess of returns over a market cap benchmark of 2 per cent a year since 1962.

Supporters also argue that fundamental ETFs give exposure to Main Street rather than Wall Street – factors such as actual earnings and dividends rather than expectations of the growth of future profitability and pay-outs. This means they have a bias more towards so-called value stocks than growth shares.

Dodd Kittsley, director of ETF research at State Street Global Advisors, says traditional ETFs are true market benchmarks while those based on alternatively weighted indices are more akin to strategies.

He says market cap indices are best suited for asset allocation purposes as they reflect the actual value of a market. Conversely, ETFs based on alternatively weighted indices are best suited for tactical investments.

“Indexes weighted by fundamental factors [and ETFs based on them] that emphasise high dividend stocks may be appropriate this year but may not be in the next,” he says.

That raises questions for investors in fundamental indices. Value stocks have recently trounced growth peers, outperforming the market for seven years in a row. If growth stocks are due a relative recovery, is it the right time to be investing in ETFs that have a value bias?

However, some argue that fundamental indices can mitigate the cyclicality of market swings between periods of growth and value stock outperformance.

Eric Brandhorst, director of research for global structural products at SSGA, says that when value stocks have had a good run and are rated close to growth stocks, the valuation tilt of fundamental ETFs relative to the rest of the market is reduced. But tilt increases when value stocks have underperformed and are due for a rebound.

Fundamental ETFs are not without critics. John Bogle, founder of index fund pioneer Vanguard, says those behind fundamental ETFs claim variously that they represent a “new wave” in indexing, a “revolution” that will offer investors better returns and lower volatility, and a “new paradigm”.

“Of course they come armed with vast statistical studies that prove how well their methodologies have worked in the past,” he says. “But think for a moment about the realities: in mutual fund investing, the past is not prologue. Yet these new paradigmists casually ignore that.”

Mr Bogle says ETFs that are not based on broad market exposure will lead to the “near-inevitability” of counter-productive market timing. Combined with heavy trading commissions and fees, this would be hazardous to investors’ wealth.

But while there is plenty of education work still to do on fundamental ETFs, they seem to have arrived as another tool in the kit of investors.

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