Cap-Weighted Index Funds - Worse than you think?

The title is maybe decieving depending on your perspective, and I wanted to generate discussion on the topic of index funds for longer term investors.  I'll include background on some fund types for those who are unfamiliar.

Most people compare returns in the stock market to the S&P 500 or Russel 1000.  While historically indexes like the S&P 500 have returned compounded annual rates better than most active traders/investors/hedge fund managers/etc have returned for people after fees, it is my opinion that it isn't that great.  The reasons are logical and fundamental.

Cap-weighted funds hold higher percentages of larger stocks.  For example in the Russel 1000 the largest stock will make up the largest percentage of the index and the smallest stock will barely affect the index as it will represent only a tiny portion of the index.   So why is this bad?  As a stock becomes more overvalued the fund will own more and more of that stock.  As a company becomes more undervalued the fund will own less and less of the stock.  This affect will cause us to own less of the cheap companies and more of the expensive ones.  This means that it does well when bubbles such as the .com bubble fuels the fund as they are on the rise, but will ultimately come crashing down once the market figures out these stocks are overvalued.  Similarly it will fail to gain from stocks that are oversold when the market realizes their value.  In this way cap-weighted funds are fundamentally set up to be less than stellar.

So what other index fund strategies or alternatives to cap-weighted? 

One is equal weighting. This is where say where a fund equally weights the percent owned of each company.  Say equal weightings of the companies in the S&P 500, such as the RSP.  The benefits here are that we don't have the buying more overbought and selling more oversold companies, so the effects should basically cancel each other out. 

Another is fundamentally weighting.  In this instead of using market cap to weight the stock percent in the index, stocks are weighted by the size of their earnings, cash.  An example PRF. This prevents the index from being overtaken by these more emotional mispricings like the .com bubble. Also less transactions since usually companies earnings do not change often should decrease fees.

A third option is based on value.  In this the index comes up with someone way to assess value, could be as simple as P/E.  Then the fund takes best of these of maybe the largest 1000 companies.  Then the funds typically either equal weights them or weights them by market cap. Examples are the IWD or VTV. However one problem is that it doesn't take advantage of weighting the best valued companies (determined by whatever metrics the fund decides) the with the most weight.   There is only one fund (as far as I know) that does weight by it's determined value but it is a mutual fund index and you can't get it at tradeking.  It is FVVAX. To me this makes the most sense for a long term investor in the stock market. It attempts to buy undervalued companies and stay away from overvalued ones. The benefits is that it should avoid any bubbles, but the downside is that it will not benefit from the rise you will see in say the S&P 500 due to bubbles or unsubstantiated increases in stock prices. Also it may have slightly higher fees than say a cap or equal weighted index since there would be more transactions as companies move from undervalued to overvalued and overvalued to undervalued.

http://www.valueweightedindex.com/  has some more information and pretty charts, figures and returns for different types of index funds.

So recapping, while the S&P 500 does provide a source of adequate returns to your capital for lazy investor approach, it is my opinion this are better ways than market-cap weighting for returns for purely fundamental reasons. I welcome further discussion.

Interesting.  How long have you had the position and how is it working out.  Seems like it would be really profitable if the market tanks and maybe bad if the market skyrockets.  Current sentiment seems to think the the former than the latter.  How does it seem to work out when it isn't moving much?  I guess I could look at the two on a chart, but would rather get the insight straight from the source.