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Fixed income embraces fundamental indexing

by Luke Smithy on Dec 28, 2012 at 07:00

Fixed income embraces fundamental indexing

With the concept of smart beta becoming common currency, debate over the value of fundamental indexing is moving up the agenda once again.

While largely focused on equities so far, these so-called intelligent benchmarks also potentially have a role to play with fixed income exchange-traded funds (ETFs), with critics questioning whether the indices they track are sufficiently representative of bond markets.

Fundamental indexing finds its roots in the US, where it is championed by groups such as Research Affiliates and WisdomTree. It is grounded in the idea that market cap is an inefficient way of indexing, because share prices are largely sentiment-led and not driven by fundamentals.

Earnings and dividends

At WisdomTree, for example, the group’s products are dividend and earnings-based and chief investment strategist Luciano Siracusano is confident these can generate alpha within a passive structure.

‘After the internet and technology bubble led to severe bear markets in the US, Europe and Japan, greater scrutiny came on a potential flaw inherent in cap-weighted indexes: their tendency to overweight overvalued stocks, sectors and regions of the world,’ he says.

‘Dividend-weighted indexes had the historically highest dividend yields and lowest beta of the factors tested, which are important attributes for investors looking for a more conservative way to generate income on equity investments.

’Perhaps most critically, our research indicated dividend-based indices provided the best preservation of capital in down markets.’

Explaining its focus on these two measures, WisdomTree highlights the fact that from 1926 through to 2007, reinvestment of dividends accounted for 96% of the stock market’s total return after inflation.

Research Associates chairman Rob Arnott – among the fathers of fundamental indexing – believes the innovation could be even more important for bonds than equities.

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