Rob Arnott, founder of Research Affiliates, the Newport Beach, Calif.-based purveyor of fundamentally weighted indexes, was emphatic when he told IndexUniverse.com Managing Editor Olivier Ludwig that investors should avoid cap-weighted bond indexes because they inherently favor companies and countries that have too much debt. He’s also convinced that his company’s fundamentally weighted RAFI indexes are a way to avoid overweighting debt-gorged entities. Scouring the investment landscape at a time when some strategists are worried the global economy may be heading into another slowdown, Arnott said he sees a potential “generational buying opportunity” in emerging markets debt.

Why are there so many bond ETF rollouts these days?

Firstly, the early successes in the ETF world were related to equity indexes—notably plain-vanilla U.S. equity indexes. And we’ve seen product proliferation as people began to realize that ETFs were a natural way to handle a whole array of strategies, indexes and even asset classes. So, I think what we’re seeing is a natural evolution, much as we saw in mutual fund index funds a couple of decades ago—in terms of more diversity and more choices for the investors.

Can you speak to bond indexing in general, in terms of pricing problems, the decentralization of bond markets and other challenges unique to the world of bonds?

I think that the biggest challenge is that most of the bond ETFs and bond indexes are linked to cap-weighted indexes, which guarantees that if a company or a country has issued a lot of debt, then you’re going to own a lot of it. In a corporate ETF or bond fund, most of your money will be with the most indebted companies, and with a sovereign debt fund, it will be with the most indebted countries.

An obvious, illustrative example is Greece, which makes up 1.5 percent of the cap-weighted developed world sovereign debt market and has only 0.8 percent of the world’s GDP. So it’s got nearly a double weight relative to GDP. That’s serious.

That reflects the gist of their problems, doesn’t it?

Right. And they’re looking to France and Germany to backstop them. France and Germany already collectively have 14 percent of the cap-weighted sovereign debt market (excluding emerging markets) and only 13 percent of the world GDP. So Greece is looking to be backstopped by countries that are already a little over-leveraged.

So this leads into an argument for what your firm is up to. You can control for these distortions?

That’s exactly right. If you weight companies according to how big they are instead of how big their outstanding bond obligations are, you’re going to be weighting companies according to their resources and their ability to service debt, not according to how much debt they’ve got. The same thing applies to countries. If you weight countries according to objective measures of the size and scale of the country and its economy, you end up not being pulled into having most of your money with the most indebted countries. It really is a global issue.

The U.K. is 6 percent of world bond market cap. How big is it? It’s 1 percent, which is a nice proxy for resources. It’s 3 percent of world population, 5 percent of the GDP and it’s 3 percent of the aggregate energy consumption, which is a crude measurement of the advancement of the economy. So you’ve got four measures here: area for resources, and population for available contribution to labor, GDP and energy, and on all four dimensions, the U.K. is anywhere from 1 to 5 percent of the world economy, and it has 6 percent of the world’s debt.

Apart from the cap-weighted issue, do bond market indexes make sense in terms of pricing and other challenges that make bond markets opaque places to transact?

That is a challenge if you have a high-turnover strategy. If you have a low-turnover strategy, the opacity of pricing and fair value becomes a less critical issue. If the prices are asynchronous or are downright wrong, it doesn’t hurt you as bad in low-turnover strategies. And bond indexes, whether they’re fundamentally weighted or cap-weighted, tend to be relatively low turnover.

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