Over time, traditional market-cap weighted indexes such as the S&P 500 and the Russell 1000 have been shown to outperform most active managers. However, market cap weighted indexes suffer from a systematic flaw. The problem is that market-cap weighted indexes increase the amount they own of a particular company as that company's stock price increases. As a company's stock falls, its market capitalization falls and a market cap-weighted index will automatically own less of that company. However, over the short term, stock prices can often be affected by emotion. A market index that bases its investment weights solely on market capitalization (and therefore market price) will systematically invest too much in stocks when they are overpriced and too little in stocks when they are priced at bargain levels. (In the internet bubble, for example, as internet stocks went up in price, market cap-weighted indexes became too heavily concentrated in this overpriced sector and too underweighted in the stocks of established companies in less exciting industries.) This systematic flaw appears to cost market-cap weighted indexes approximately 2% per year in return over long periods.

One way to avoid the problem of buying too much of overpriced stocks and too little of bargain stocks in a market-cap weighted index is to create an index that weights each stock in the index equally. An equally-weighted index will still own too much of overpriced stocks and too little of bargain-priced stocks, but in other cases, it will own more of bargain stocks and less of overpriced stocks. Since stocks in the index aren't affected by price, errors will be random and average out over time. For this reason, equally weighted indexes should add back the approximately 2% per year lost to the inefficiencies of market-cap weighting.

Fundamentally-weighted indexes weight companies based on their economic size using measures such as sales, book value, cash flow and dividends. Similar to equally-weighted indexes, company weights are not affected by market price and therefore pricing errors are also random. By correcting for the systematic errors caused by weighting solely by market-cap, as tested over the last 40+ years, fundamentally-weighted indexes can also add back the approximately 2% lost each year due to the inefficiencies of market-cap weighting ( with the last 20 years adding back even more!).

On the other hand, value-weighted indexes seek not only to avoid the losses due to the inefficiencies of market-cap weighting, but to add performance by buying more of stocks when they are available at bargain prices. Value-weighted indexes are continually rebalanced to weight most heavily those stocks that are priced at the largest discount to various measures of value. Over time, these indexes can significantly outperform active managers, market cap-weighted indexes, equally-weighted indexes, and fundamentally-weighted indexes.