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Fixed income embraces fundamental indexing
by Luke Smithy on Dec 28, 2012 at 07:00
Just as equity market cap indices are driven by share prices rather than fundamentals, bond benchmarks that track sovereign and corporate debt are biased towards larger borrowers that have gorged on debt.
For Arnott, cap-weighted bond investors are therefore lending to those with the heaviest debt burdens. Japan, for example, has near $11 trillion in public debt and therefore makes up the largest portion of indices tracking global bond markets.
On the Barclays Capital Global Treasury Ex-US Capped Index, for example, tracked by several ETFs, Japan accounts for more than a fifth of the universe.
Among providers offering fixed income ETFs, Legal & General Investment Management managing director Simon Ellis (pictured) says conventional and index-linked gilts are both liquid markets with a relatively small number of bonds, so benchmarks are representative and provide genuine beta.
‘If we launched fixed income index funds in future, we would look for broad indices that offer investors sufficient risk protection and a cost-effective means of accessing the asset class,’ he adds. ‘At this stage, we do not believe index products based on less liquid fixed income assets, such as high yield, are likely to mitigate the risks of default or downgrading as effectively as active management.’
In an interview last year, Arnott said that while the drawback in market cap indices are clear in equities, they are ‘flagrantly obvious’ in bonds.
Answering questions from ETF Database, he added: ‘With cap weighting, consider that Australia has three times the GDP of Greece, and Greece has three times the debt burden of Australia. Why should we want to own three times as much in Greek debt as Australian debt?
‘In fact, Australia’s ability to service debt is at least three times that of Greece, and so wouldn’t it make more sense to have an index for bonds that weights countries’ bond debt in accordance with GDP and other measures of the economic footprint of a country?’
Continuing its record of innovation in this space, PowerShares was the first to use one of Research Affiliates’ RAFI benchmarks, converting its high-yield bond strategy to a fundamental high-yield bond index.
‘When you go back historically, the fundamental index applied to high-yield bonds adds over 300 basis points per year going back for the 14 years we were able to test,’ adds Arnott.