Key Points:

• By equating price appreciation with business growth, market capitalization-weighted growth indices tend to favor expensive stocks over those with real growth potential.

• Portfolios constructed based on sales and profit growth, among other income statement metrics, prioritize business performance and innovation over value retention and distribution and tend to outperform portfolios built on more balance sheet-related criteria.

• The RAFI Fundamental Growth Index is designed to identify real growth companies that deliver tangible expansion in actual growth metrics while reducing exposure to glamorous stocks with frothy valuation multiples.

• Since index launch, the RAFI Fundamental Growth US Index outperformed the S&P 500 and a blend of growth benchmarks by 7.7% and 10.4%, respectively, with security selection rather than sector allocation driving most of the excess gains.

“Growth” is one of the most beloved and misunderstood attributes in investing. Investors benefit from a company’s ability to deliver growing profits to its shareholders while not overpaying for those opportunities. Hence, the irony that many growth indices today incorporate market capitalization in both their selection and weighting processes: In our view, they effectively conflate price appreciation with business growth and systematically steer investors toward the most glamorous and expensive stocks in the market rather than those with actual growth potential. The result is narrow and expensive growth exposure that is vulnerable to valuation reversals.

[M]ost growth indices today incorporate market capitalization in both their selection and weighting processes: In our view, they effectively conflate price appreciation with business growth.

We introduce a fundamentally different approach.

Eschewing the notion that expensive equates to growth, we abandon the peculiar constraint that growth and value indices must collectively span the market¹ and instead start with a simpler premise: Growth should be defined by a company’s ability to expand its economic footprint. Growth investors may improve outcomes not only by reimagining how growth stocks are selected but also by moving away from market-cap weighting and toward a weighting method that reflects a company’s macroeconomic growth.

Selecting with Fundamental Growth

If conventional growth indices, in practice, tend to select what is expensive, the key question becomes: What actually signals real growth? We begin with measures that demonstrate past and future business growth. This leads us to focus on income statement growth rather than balance sheet growth. The distinction is important. Income statement growth rewards shareholders through increasing sales and profits, while balance sheet growth often reflects capital accumulation that does not necessarily translate into shareholder value.

From a shareholder’s perspective, the most relevant growth indicators will capture superior sales and profit growth and sustained innovation as drivers of continued growth. Exhibit 1 shows these measures in blue.² By contrast, book value and dividend growth, highlighted in yellow, tend to be associated with empire building and bond-like income distribution. Past research indicates that these types of growth do not add value.³ Balance sheet growth, in particular, can be backward-looking or capital-intensive, while income-statement growth is economically scalable and more closely tied to future economic outcomes.

To test these priors, we form portfolios using each growth fundamental to select stocks.⁴ We calculate growth over a five-year period and normalize by sales per share to allow for meaningful comparisons across different-sized firms. This includes those with zero or negative profits, dividends, and R&D, and accounts for possible dilution. We describe this as the rate of growth. A sample calculation for R&D is as follows:

Next, we construct cap-weighted portfolios with varying concentrations of 500, 200, and 100 stocks and rebalance annually in March. We also simulate two benchmarks: True Cap 1000 and Cap Weight Growth (CW Growth). True Cap 1000 selects the top 1,000 stocks by market cap while CW Growth creates a generic growth index by following a methodology similar to other standard growth indices. (Historical simulated returns are comparable to the legacy growth indices.) By building our own CW Growth index, we can examine a longer time series that spans more than a half-century.⁵ Exhibit 2 shows our results.

In the income statement growth metrics, returns exceed benchmarks and rise monotonically with concentration. For balance sheet growth metrics, the results are mixed at best: Only two of the six beat the market, by insignificant margins, and greater concentration doesn’t necessarily help. This confirms our intuition that portfolios focused on business performance and innovation tend to deliver excess returns, while those that prioritize value retention and distribution do not.

Weighting by Fundamental Growth

Selection determines which companies to own. Weighting determines how much to own. For growth investors, this distinction is critical. Our portfolio tests use cap weighting to facilitate comparison with cap-weighted benchmarks. While often treated as neutral, cap weighting can embed a specific assumption: It systematically allocates more capital to the most expensive stocks. For growth investors, this is not a neutral stance, it is an active bet that the most richly priced growth stocks will exhibit the greatest valuation expansion.⁶

We employ a different framework. Rather than weighting by market value, we propose weighting by the growth magnitude as a claim on economic growth itself. Whereas the rate of growth is normalized by sales, growth magnitude is the raw dollar change, as this sample calculation shows:

To avoid negative weights, we establish a floor of zero for companies with negative growth. Weighting by growth magnitude sizes each stock in proportion to its contribution to total economic growth. The results in Exhibit 3 confirm that market-cap weighting leaves money on the table for growth investors, while weighting by growth magnitude improves outcomes across all concentration levels.

Fundamental Growth

To increase robustness, we combine these growth metrics into a single composite measure that captures multiple facets of growth without over-relying on any single growth dimension.

For selection, we compute the composite growth rate by normalizing each firm’s growth rate using z-scores and then averaging across these z-scores. To calculate the composite weighting, we measure each firm’s dollar magnitude as a percentage of the aggregate of all stocks that made the cut and average the growth weight across the three metrics.

Exhibit 4 shows the results for the Fundamental Growth portfolios, both for cap weighting each portfolio (CW) and for fundamental growth magnitude weighting (FG) at various concentration levels.

The composite portfolio outperforms both cap-weighted growth benchmarks and cap-weighted versions of the same portfolios at all levels of concentration, with the largest outperformance at the most concentrated level. As we narrow our lists of rapidly growing companies, returns increase monotonically, as do the incremental returns from FG weighting. Fundamental weighting may also improve Sharpe ratios.

Return Decomposition

To better understand the source of outperformance, we examine returns along statistical and fundamental lines. Exhibit 5 shows the statistical decomposition, which applies the Fama-French-Carhart four-factor model.

As with the raw returns, the simulated FG versions dominate their CW peers, and with larger alphas and stronger significance based on their t-statistics. Increasing concentration boosts alpha, which rises from 2.4% for FG 500 to 6.4% for FG 100. More striking is traditional value’s role in the Fundamental Growth portfolios. At each level of concentration, the growth-weighted version has a larger (i.e., less negative) HML exposure relative to its cap-weighted equivalent. This means that fundamental weighting harvests growth without systematically overpaying for it.⁷ As a result, FG 200 delivers three times the factor-adjusted alpha as CW Growth and one-third more statistical significance, with the exact same classically defined HML growth bias.

Our fundamental decomposition provides further insight. We decompose returns into the key components of income, EPS growth, and valuation change (P/E expansion)⁸ to distinguish between sustainable fundamentals-driven returns (income, EPS) and less sustainable multiple expansion-driven returns. We conduct this decomposition on excess returns relative to True Cap 1000 to assess and compare the sources of relative performance. Exhibit 6 shows our findings.

The CW Growth portfolio delivers 0.9% faster earnings growth than the market but gives 0.8% of that back because of its lower dividend income. Across all Fundamental Growth specifications, stronger EPS growth drives excess returns. Multiple expansion plays no role. As excess returns increase with concentration, EPS growth’s contribution rises monotonically.

Furthermore, stronger EPS growth rather than valuation expansion or dividends is responsible for the performance advantage of the growth-weighted portfolios over their cap-weighted counterparts. This confirms that the excess returns of the Fundamental Growth approach are rooted in real fundamentals-based growth rather than revaluation or payout effects.

This superior EPS growth was achieved with less sector concentration than the legacy indices. Exhibit 7 shows the sector allocations of the FG 500 and CW Growth simulated portfolios. While CW Growth has experienced bouts of concentration in technology during the tech bubble of 1998 to 2000 and again over the past decade, FG 500 has maintained a more balanced exposure. While hype can stretch the valuations of certain sectors to extraordinary heights, almost any sector can see rapid sales or profit growth. This reduced sector concentration at market extremes leads to far more consistent performance across varied market cycles.

RAFI Fundamental Growth US Index

Encouraged by our findings, we launched an index incorporating these principles in July 2025. The RAFI Fundamental Growth US Index incorporates additional robustness practices,9 but the philosophy – to select and weight based on fundamental growth rather than price – remains the same. While the live track record is relatively short, it provides an out-of-sample test of our research. Exhibit 8 shows how the RAFI Fundamental Growth US compares with the S&P 500 and an average of four growth indices from S&P, Russell, MSCI, and Bloomberg during this brief span.

During the initial live period, RAFI Fundamental Growth US delivered 10.7% and 14.5% higher returns than the S&P 500 and the blend of growth benchmarks, respectively. An attribution analysis versus the Russell 1000 Growth ETF (IWF) shows that security selection rather than sector allocation drove the bulk of the outperformance, reinforcing the importance of the selection and weighting framework.

The large outperformance in recent months, while exciting, is unlikely to be representative of long-run results. A backtested analysis of five-year rolling returns shows that RAFI Fundamental Growth US tends to outperform standard growth indices by 2% to 4% annualized. This has persisted in strong markets (2015 to 2019), bear markets (2007 to 2009), value-dominated markets (2005 to 2007), and growth-dominated markets (2021 to 2024). While the 1.000 batting average in relative five-year returns is impressive, what’s more impressive is the 85% and 72% reliability, respectively, on rolling three-year and rolling one-year relative returns.

Exhibit_9_Strapi.html

The fundamental ratios and statistics in Exhibit 10 also tell an interesting story. The RAFI Fundamental Growth US trades closer to core than traditional growth valuation multiples. By avoiding price in the selection and weighting process, RAFI Fundamental Growth US includes nicely growing companies if they are cheap. Conventional growth indices will often exclude these companies simply because they are cheap! Even in a market where a few stocks dominate the headlines and the cap-weighted indices, investors can still find growth without paying a hefty premium.

By avoiding price in the selection and weighting process, RAFI Fundamental Growth US includes nicely growing companies if they are cheap. Conventional growth indices will often exclude these companies simply because they are cheap!

Concluding Remarks

By embedding price directly into both selection and weighting, conventional growth indices can mistake expensive valuations for growth. This leads to a concentrated, valuation-sensitive portfolio that relies heavily on multiple expansion. We aim to avoid this mistake by not perpetuating the idea that growth and value indices must jointly define the market.¹¹ By selecting stocks based on fundamental growth in sales, profits, and innovation and weighting them according to their contribution to that growth rather than their market price, we target real, repeatable, and economically meaningful growth.

Fundamental Growth separates growth from glamour. It focuses on companies delivering tangible expansion in real growth metrics while seeking to reduce exposure to stocks whose “growth” image reflects frothy valuation multiples. In a market increasingly dominated by a narrow set of expensive names, getting growth right means focusing on actual growth. Fundamental Growth is designed to offer a clear, disciplined way to do exactly that.

In a market increasingly dominated by a narrow set of expensive names, getting growth right means focusing on actual growth. Fundamental Growth is designed to offer a clear, disciplined way to do exactly that.