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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
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
That reflects the gist of their problems, doesn’t it?
Right. And they’re looking to
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.
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.