Rob Arnott, the pioneer in the world of fundamentally weighted indexes, has joined forces with Citigroup to bring his RAFI methodology to the sovereign debt space. The Citi RAFI Bond Index Series, the first two of which were launched in January, serves up exposure to sovereign bonds that’s based on a country’s ability to service its debt. At a time when many developed countries are up to their eyeballs in debt, Arnott’s latest idea seems like it might have some serious legs.

In an interview with IndexUniverse.com Managing Editor Olivier Ludwig, Arnott explained why the RAFI approach makes sense in a sovereign debt market that is far from fully developed. Moreover, investors are keenly aware of the pitfalls of strategies that bet big on debt-laden players, and the founder of Newport Beach, Calif.-based Research Affiliates said his RAFI methodology is the perfect tool for the times.

Olivier Ludwig:  You have some agreements in place in the fixed-income space—I’m thinking of PowerShares—but until now, not in the sovereign space. Is that correct?

Rob Arnott: That’s correct. We took the idea to a variety of index providers. And the one that seemed to be the best fit was Citi.

Ludwig: Why is that?

Arnott: For us, Citi represents a partner with tremendous global reach. And for Citi, teaming up with us, provides them with a methodology to create alternative indexes that complement their existing line of products.

Ludwig: Did it give you pause working with Citi? You still hear some people say: “Look at Citi’s stock since 2008—it’s hardly done a thing!” It seems as if there’s lingering concern that there’s a lot of that’s not been dealt with at that organization in terms of writing down bad assets. Is that something that crossed your mind at all?

Arnott: I view Citi as a very solid partner. The thing I like about it is that they’re committing resources, and they aren’t merely offering the index in an agnostic fashion. They’re offering it in a proactive way saying, “Here’s a very good idea that we think will add value.”

Ludwig: Can you speak to the first two indexes in the series that you introduced last month? Why these two and why were they emphasized at the outset?

Arnott: The sovereign debt crisis has highlighted the need to construct alternative government bond indexes. While the recent focus has been on Europe, let's look elsewhere. Japan accounts for one-third of a developed-markets cap-weighted index. Yet Japan has a rapidly aging population, a debt-to-GDP ratio close to 200 percent, and their bonds pay a relatively skimpy yield.

Down the road, we easily could see a re-valuation of Japanese government debt. In the Citi-RAFI Sovereign Developed Markets Bond Index, Japan accounts for only 9 percent of the weighting. It seems to us that weighting a bond index in proportion to underlying economic scale makes more sense than weighting in proportion to the outstanding debt.

As you may know, we use four measures reflecting four factors of production in a healthy well-functioning economy. One of those factors is capital; another is labor; another is resources. Then the fourth is energy consumption of the nation as a gauge of whether the country is advanced enough to put the second and third factors, labor and resources, to work.

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