The big idea: When bringing a new idea to market, should you partner with another firm or implement it yourself?

The scenario: In March 2000, equity indices such as the Standard & Poor’s 500-stock index were at record highs, largely as a result of the skyrocketing share prices of Internet and technology firms. Higher prices meant higher market capitalizations and, as a result, market-cap-weighted indices took larger and larger positions in these stocks. Tech stocks had much larger market-cap weights in their respective indices than their firm fundamentals would suggest, and many professional investors believed that these market valuations were not supported by their future earnings potential. Cisco, for example, was 4.1 percent of the Russell 1000 due to its enormous market capitalization, but it accounted for an average of only 0.2 percent of the aggregate sales, cash flow, dividends and book value for all 1,000 stocks in the index.

By March 2002, the tech bubble had burst. Despite efforts to diversify beyond technology, many institutional investors suffered dramatic declines. Because their portfolios invested in or were benchmarked against the S&P 500 or other cap-weighted indices, they were highly weighted toward the technology sector.

This collapse of the tech bubble exposed a potential weakness in cap-weighting. Rob Arnott and Jason Hsu had recently founded Research Affiliates, a California-based investment adviser. Recognizing the opportunity inherent in this weakness, they embarked on an ambitious research project to identify a better weighting scheme. Their efforts yielded a dramatic insight: weighting stocks by firm fundamentals such as cash flow, sales, book value and dividends resulted in superior performance. The Fundamental Index strategy they developed outperformed cap-weighted indices by more than 2 percent a year with no difference in volatility.

In an industry where superior performance is the key to attracting investors, Arnott and Hsu had uncovered a simple but highly effective investment strategy that consistently beat common cap-weighted benchmarks. To many investment professionals, an obvious next step would be for Research Affiliates to start a fund using the investment strategy Arnott and Hsu had identified. If the fund outperformed others to the extent that the research suggested, it would be able to expand the fund’s assets under management, and Research Affiliates could earn advisory fees on those assets.

At the same time, success breeds imitation, and for Research Affiliates to successfully compete with those imitators, the firm would have to focus its resources on managing and marketing the fund. Implementing just one of those ideas might detract from the firm’s efforts to generate investment ideas, and Research Affiliates prided itself on its ability to “create innovative strategies that respond to the current needs of the market.”

The resolution: Instead of managing the assets itself, Research Affiliates contracted with FTSE, an independent company owned by the Financial Times and the London Stock Exchange, in 2005 to calculate and license its Fundamental Index methodology. Later that year, Invesco Powershares launched the first exchange-traded fund tracking the Fundamental Index, and within several years, numerous partners licensed the methodology from FTSE or Research Affiliates. Although Research Affiliates does manage some Fundamental Index strategy assets directly, the majority of its assets are managed by third parties, and it receives an asset-based license fee for the use of its intellectual property (indices) and the data provided. Thanks to those strategic partnerships, the Fundamental Index idea has grown rapidly. By the end of 2011, more than $50 billion was being managed under the approach.

The lesson: Research Affiliates’ business model is unusual within the investment industry. Most investment advisers generate revenue from their advisory fees on directly managed assets. Although directly managing assets would enable Research Affiliates to charge larger percentage fees, the firm recognized that its competitive advantage was in innovation. Focusing on implementing the Fundamental Index idea would have detracted from its efforts to generate other investment ideas. Michael Larsen, director of affiliate relations, put it this way: “Our mission is to identify and develop great investment products. Then we partner with others to bring those investment ideas to market.” With more than $80 billion in assets managed using Research Affiliates ideas, the strategy appears to be succeeding.

— Richard B. Evans

Evans is assistant professor of business administration at the University of Virginia Darden School of Business.