Rob Arnott, founder of Research Affiliates, the Newport Beach, Calif.-based purveyor of fundamentally weighted indexes, told IndexUniverse.com Managing Editor Olivier Ludwig he’s all but sure that before long, one his firm’s RAFI fundamental indexes will be attached to local-currency emerging market ETFs like those recently launched by Van Eck and WisdomTree. More broadly, while he’s convinced that his firm’s indexes are a better mousetrap for capturing higher returns with lower risks, he’s realistic about how long it might take “wacky” bond markets to give up their fixation with cap-weighted indexes. It won’t be a RAFI revolution; it’ll be a slower RAFI evolution that could take as long as 10 years to coalesce.

Ludwig: Do you have anything in the works along the lines of the recently introduced Van Eck and WisdomTree emerging market debt ETFs holding debt denominated in local currencies?

Arnott: This is an area that I find both interesting and exciting on a lot of levels. The short answer is: No, we’ve got nothing going on in that space that’s imminent. The longer answer is I’ll be astonished if we don’t in the next year or two.

The emerging markets as a percentage of GDP are 37 percent, and as a percentage of world sovereign bond debt, they’re 10 percent. And developed countries are reciprocally 63 percent and 90 percent.

RAFI for bonds simply takes the view that you’re way better off in the bond world weighting according to capacity to service debt rather than weighting in accordance with the size of the debt. So, for example, Australia’s economy is three times the size of Greece’s economy, and Greece’s debt is three times the size of Australia’s debt. In effect, Australia is nine times more solvent than Greece, and a year ago their yields were the same.

If you look at countries’ debt as a percentage of total world sovereign debt, and then if you at countries’ GDP as a percentage of total world GDP, what you find is that most of the developed economies are debt-gorged, and most of the emerging economies are not. And that invites the question: Why on earth is emerging markets debt priced at a risk premium relative to markets that objectively are riskier?

Ludwig: Now how do you separate the wheat from the chaff in the emerging space? Not all these countries are created equal on a number of levels.

Arnott: If you want to do a fundamental index for sovereign debt, there is no business size to measure; there is a size to the country, its population and its economy. RAFI for sovereign debt implies weighting the countries according to how big their economy is, how big their country is and, tacitly, how big their debt-service capacity is—and not in accordance with the size of their debt burden.

The short answer to your question is that we don’t dive in to measure solvency ratios or debt-coverage ratios or political will to service debt. For example, the president of Ecuador abrogated on their sovereign debt even though they had enough money in the bank to write a check for the total sum. He did so because he felt that the lenders were rapacious and didn’t deserve repayment.

Ludwig: So your screen wouldn’t save an investor from the Ecuador situation.

Arnott: Correct. That’s political risk. That’s not the kind of risk that you can necessarily quantify.

If you think of RAFI as a passive index of the world economy weighted according to debt-service capacity, then if a country—say Greece—doubles its debt burden, our response would be: We’re not changing the amount we’re willing to lend them, so somebody else has to lend them that difference.

And regarding some country like Australia that has very little debt, we’re basically taking a view that they have lots of debt-servicing capacity, so let’s go ahead and lend them this money whether they’re asking for it or not by owning their bonds in proportion to the magnitude of the economy.

It’s really a simple intuition that works remarkably well.

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