SAN DIEGO (ETFguide.com) - With most investment strategies from stock picking to buying individual bonds all in the red many investors are wondering what they can do to thrive during a bear market? 

Maybe ETFs that follow the discipline of fundamentally designed indexes are the answer. Have they lived up to their promise? 

A quick gander at the exchange-traded funds (ETFs) following these alternative indexing strategies reveals a mixed bag in performance.

For example, fundamentally designed ETFs in the large cap category are underperforming whereas others that focus on small and mid-cap stocks are slightly outperforming.

Just the Numbers, Please

Through mid-November, the PowerShares FTSE RAFI 1000 (NYSEArca: PRF - News) has declined 40.9 percent this year compared to a decline of just 37.9 percent for its matching passive benchmark, the large cap Russell 1000 (NYSEArca: IWB - News). The PowerShares FTSE RAFI 1500 (NYSEArca: PRFZ - News) which owns small and midcap stocks has slightly outperformed ETFs (NYSEArca: VXF - News) investing in the same area, but with a passive strategy.

Fundamental ETFs attempt to beat the performance of traditional indexes by selecting and weighting stocks according to various financial metrics like earnings, dividends, or book value. Most traditional indexes like the S&P 500 select stocks passively and use a market cap weighting.

Even within the industry sector category, the year-to-date performance of fundamental ETFs are once again mixed.

For the 7 PowerShares FTSE RAFI industry sector funds, just 3 (Consumer goods NasdaqGM: PRFG, Energy NasdaqGM: PRFE, and Utilities NasdaqGM: PRFU) are beating the Select Sector SPDRs, which offer passive ETFs following the same sectors. Traditional index ETFs following basic materials (NYSEArca: XLB - News), financials (NYSEArca: XLF - News), industrials (NYSEArca: XLI - News), and healthcare (NYSEArca: XLV - News) continue to win.

In real estate investing, the fundamental strategy has been losing to traditional passive strategies.  

The WisdomTree International Real Estate Fund (AMEX: DRW - News) has fallen 58.6 percent and the PowerShares FTSE RAFI International Real Estate Fund (NYSEArca: PRY - News) is down 56.2 percent compared to a decline of just 53.1 percent for the SPDR DJ Wilshire International Real Estate Fund (NYSEArca: RWX - News).

Whenever you compare the performance of fundamentally designed ETFs, it's important to match them with traditional index ETFs that correspond to the same asset category along with market size and to use the same period of performance history.

Better Education Needed

Fund companies and index providers pushing ETFs that follow alternative or fundamental indexes need to do a better job of educating the public about how their products work. This is evident by the product disclosure omissions on Websites and government required filings.

For example, many prospectuses and marketing materials for fundamental ETFs do little to offer transparent or coherent explanations about how securities are being selected, deleted, weighted and rebalanced. Shame on fund marketers! In fact, some funds completely skip transparency by saying that the investment methods for their underlying indexes are 'proprietary.' What besides nothing does that mean?

In his latest book, (The ETF Book, John Wiley 2008) Richard A. Ferri, CFA describes a groundbreaking tool he calls 'Index Strategy Maps.' The point of the tool is to help investors decipher how the indexes behind their ETFs are constructed and managed.  

According to Ferri's research, the two main aspects of an index's construction are: 1) how it selects securities and 2) how the securities are weighted.

It's unfortunate that most fundamental indexers continue to focus on how their fund's weight underlying holdings, while simultaneously neglecting to discuss how these indexes are selecting securities. Investors deserve to know the whole story, not half of it!

At ETFguide, we've embraced Ferri's revolutionary Index Strategy Maps (see below). It is the only financial tool to this point that simply and elegantly explains what your index ETFs are truly doing.

If you don't have a clear understanding of what strategies your ETFs are following, how can you make informed financial decisions? The answer is you can't.

Conclusion  

The performance figures presented in this article are far from conclusive in determining the superiority of fundamental indexing or the ETFs following them. At best, during the short runs observed we can say that it's worked about half the time and in some cases doesn't seem to work at all.

Like others, I've observed that most fundamentally designed ETFs have a bias towards small company and value stocks. Even though these biases may have produced historical outperformance over long-periods of time, there's absolutely no guarantees they will do so in the future and even more importantly, when the people investing them need their money.

Where do fundamentally designed ETFs fit into your portfolio's design?

After you've laid the foundation of your portfolio to a diversified mix of ETFs that follow true or traditional index benchmarks and you have extra money you don't mind risking, then you can consider buying fundamental ETFs.

In the end, they are investments that will compliment your traditional index funds and ETFs, but not replace them.