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There is a very valid expression that we shouldn't reinvent the wheel.

Having said that, companies like Goodyear, Pirelli and BFGoodrich do it successfully all the time. In fact, I recently saw a picture of a new airless tire concept design from Michelin. With today's technology and research, it is not fair to say that we can't improve upon ideas that already seem perfect.

This same principal came to mind when I learned of some fairly new research on an investment method that has historically beaten the index by 2.1 per cent annually. Keep in mind that in the world of portfolio and investment theory, 2.1 per cent is an incredible amount of value-added, which certainly adds up over time.

A man named Robert Arnott has challenged some of the core assumptions about how a stock market index should work and how to improve upon historical index returns. His company Research Affiliates has introduced the concept of something called fundamental indexing. In order to understand it you need to know what exists presently.

We have all heard of the Dow Jones Industrial Average, the S&P500 or the S&P/TSX Composite. These are market indices. Each index is a generally accepted method of measuring an overall market. For instance, if we want to know how the U.S. stock market did today, we would probably check the S&P500 index.

Most of these indices are simply measuring how the largest stocks on the market are moving. The problem, however, revolves around the fact that each index tends to give more weight to the companies that have the largest value of shares on the market. This makes most of them market capitalization indices (or cap-weighted indices).

Just like the tires, you might say why is that a problem?

A cap-weighted index is a pretty good way to measure the overall market, but Mr. Arnott – who has received many research awards – believes there is a better way.

The inherent problem in a cap-weighted index is that every stock that is overvalued is over weighted in the index and, therefore, your portfolio if you are using an index to invest. Likewise, every stock that is undervalued is underweighted in the portfolio. If a company suddenly doubles in value, you might say, "Why do I suddenly want to own twice as much of it?" This brings back memories of when Nortel made up approximately 30 per cent of the Canadian index.

For the last 50 years, academics have more or less shrugged their shoulders at this problem and said that determining overvalued and undervalued companies is not possible. The twist that Research Affiliates puts on their own index is that they use what they call Main Street measurements. They look at how large a company is in terms of things like book value, income, sales and dividends.

Back-testing by Research Affiliates for the period of 1962 to 2005 shows that their method would have produced a return that was 2.1 per cent superior to the S&P500 on an average annual basis.

They were also able to produce similar results in markets all around the world.

Their concept of fundamental indexing may not be akin to completely reinventing the wheel, but researching their results makes me believe that they have possibly built a better mousetrap.

The opinions expressed are those of the author and may not necessarily be those of Manulife Securities Incorporate, Member CIPF. Greg MacPherson, BBA, CFP, FMA, CSA, FCSI, is a Financial Advisor in the Woodstock branch. Contact his office with questions or to book an appointment: 328-8889.