Fundamental Bond Indexing

The Journal of Indexes an article by Shane Shepard of Research Affiliates (RA), laying out the case for using a scheme other than capitalization-weighting for bond indexing.  For those familiar with RA's fundamental indexing for equities, it will sound very familiar.  The premise is that in any market, securities will become subject to pricing errors.  Without conducting continuous valuation analysis on each security in the market, one cannot know which securities are priced incorrectly, nor in which direction n the error is occurring.  RA has addressed the issue by removing the security's price from the weighting mechanism.  In their equity portfolios, securities are weighted by financial statement factors.  Now, in bond portfolios, the securities are weighted by factors that are presumed to reflect credit-worthiness.  Thus portfolios of sovereign debt is weighted on factors such as GDP, population, land area, and energy consumption.  Corporate debt is weighted by sales, cash flow, dividends, and book value of assets.

For the periods studied, the fundamentally weighted portfolios outperformed their cap-weighted counterparts significantly.  The developed country sovereigns notched an 80 basis point average annual advantage over the period January 1997 through June 2011.  The emerging market sovereigns chalked up a 130 basis point of outperformance.  Fundamentally weighted corporate bonds posted similar performance improvement over well-known indexes.

These backtest results do not necessarily mean that the fundamentally weighted bond portfolios are superior to cap weighted funds.  The portfolio weighting scheme was designed specifically to overweight credit quality and liquidity relative to cap weighted indexes.  This testing period is dominated by two rounds of financial stress in which credit quality and liquidity were particularly valuable. Expect RA to publish additional research testing its fundamentally weighted portfolios over other time periods.  pay particular attention to relative performance of, say, 1982-1986 and 1992-1997.

Brian Bollen is reporting that Citi and RA are going to launch a series of global sovereign bond indexes based on the RA methodology.  Look for open en mutual funds and ETFs to follow.