How to Build a Better Index Fund

(Bloomberg Opinion) -- Index funds that use market capitalization for their construction have been around since the first fund was created 40 years ago. Rob Arnott, this week's guest on Masters in Business, figured there had to be a better way to create index-based investments. His research led him to the concept of using equity fundamentals — earnings, dividend yield, book value and other concepts — to create indexes.

Thus, the idea of so-called smart beta was born. His goal was to create funds that were still passively managed, but didn't run into issues where certain holdings became over- or underweighted — and yet still have a chance to outperform the broader capitalization-weighted benchmark indexes.

Arnott is the founder and chairman of Research Affiliates LLC, and his ideas on fundamental indexing are the intellectual property behind more than $200 billion in investment portfolios. He explains why fundamental indexing is superior to either active management or traditional indexing.

His favorite books are cited here; our conversation transcript is published here. Our 2014 interview with Arnott it is still available.

You can stream/download the full conversation, including the podcast extras on iTunes, Bloomberg, Overcast and Stitcher. Our earlier podcasts can all be found on iTunes, Stitcher, Overcast and Bloomberg.

Next week, we speak with Torsten Slok, chief international economist at Deutsche Bank AG.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Barry Ritholtz is a Bloomberg Opinion columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He is the author of “Bailout Nation.”