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Fixed income embraces fundamental indexing
by Luke Smithy on Dec 28, 2012 at 07:00
Corporate side fundamentals
To give a brief idea of how fundamental indexing works for fixed income, the Research Affiliates team considers five metrics to give a weighting on the corporate side, namely total cashflow, total dividends, book value of assets, sales and face value of the debt issue.
For the emerging market (EM) sovereign space, meanwhile, it considers various factors that signify the current and potential importance of a country in the world economy, namely total population, square root of land area (as a proxy for resources), total GDP and energy consumption.
Looking at figures published in the Journal of Portfolio Management, fundamental bond indices have broadly outperformed more traditional benchmarks. In the period from January 1997 to December 2009, a composite US high-yield portfolio based on Research Affiliates’ factors outperformed the cap-weighted index by 260 basis points a year.
Similar US investment grade and EM sovereign composites also beat their relevant indices over the period.
Writing in the Journal, Arnott and affiliates Jason Hsu, Feifei Li and Shane Shepherd said: ‘This result provides evidence that valuation-indifferent indexing works in fixed income markets. Severing the link between price and portfolio weight means the approach does not inherently overweight overvalued bonds and underweight undervalued.
‘These are typically less volatile and less risky than the Merrill Lynch indices. Furthermore, the incremental return does not generally come from credit quality or duration risk, which could be viewed as the bon analogues of value and beta. Almost all boast a superior average credit rating and duration tends to be similar to, or shorter than, the benchmark.’
Since Research Affiliates first outlined the concept of fundamental indexing in 2005, several critics have emerged, predictably from some of the older guard of indexing. Naysayers broadly focus on the active element as well as higher turnover than traditional benchmarks and therefore higher expense ratios for products tracking them.
Perhaps the highest profile is Vanguard founder John Bogle, who has rejected talk of fundamental indexing as a new paradigm.