The Citi RAFI Bond Index Series applies the methodology to the sovereign debt market, potentially reducing the risk of our fixed income portfolios while providing an opportunity to enhance returns. Instead of using traditional accounting measures to set country weights, the Citi RAFI series uses measures of economic size—GDP, population, land area, and energy consumption—and thus tends to overweight countries with high debt service capacity. These countries tend to have lower credit risk and lower duration as well, thus lending some protection against both rising interest rates and sovereign defaults. Furthermore, applying the Fundamental Index^® strategy to fixed income takes advantage of the well-documented RAFI return advantage that comes from regular rebalancing and contra-trading against noisy price movements. Our research estimates the return advantage to be 80 bps annually in the Sovereign Developed Markets and about 125 bps annually in Sovereign Emerging Markets debt. In a world of slow growth and low expected returns, these advantages are significant indeed.

Conclusion

The incentives of Dirt Economics from my grandparents’ generation have been left behind—at least in most developed countries—so my generation faces a challenging road to maintain our standard of living. As we travel that path, we all need to position our portfolios for turbulent economic times—ones that promise to be very different from the post-World War II expansionary period to which most of us are accustomed. Low expected returns, significantly higher inflation and interest rates, rising deficits and debts, and worsening demographics all figure into a “New Normal.” Adding a third “pillar” of inflation protection to our portfolios and creating the possibility of significantly enhancing index returns through application of the Fundamental Index strategy to stocks and bonds alike strengthen our hopes of avoiding a future of diminishing prosperity.

Endnotes

1. For example, see the following Fundamentals: “The ‘3-D’ Hurricane Force Headwind,” November 2009; “Debt Be Not Proud,” August 2010; and “The Long View—Building the 3-D Shelter,” October 2011. http://www.researchaffiliates.com/ideas/fundamentals.htm
2. Research Affiliates, based on data from the U.S. Census and United Nations.
3. Net new working age people is number turning 20, less number turning 65, plus net immigrants age 20–64, minus early deaths age  20–64. Net new senior citizens are number turning 65, plus net immigrants age 65+, minus deaths age 65+.
4. Arnott, Robert D., and Denis B. Chaves. 2012. “Demographic Changes, Financial Markets, and the Economy.” Financial Analysts Journal, vol. 68, no. 1 (January/February):23-46.
5. Arnott, Robert D., and Anne Casscells. 2003. “Demographics and Capital Market Returns.” Financial Analysts Journal, vol. 59, no. 2 (March/April):20–29.
6. In addition to the Fundamentals cited above, please see “A Complete Toolkit for Fighting Inflation,” June 2009; “Are 401(k) Investors Fighting Yesterday’s War?” September 2010; and “King of the Mountain,” September 2011
7. For example, see the November 2010 Fundamentals, “The Glad Game.”
8. Arnott, Robert D., Jason C. Hsu, Feifei Li, and Shane D. Shepherd. 2010. “Valuation-Indifferent Weighting for Bonds.” Journal of Portfolio Management, vol. 36, no. 3 (Spring):117-130.

©2012 Research Affiliates, LLC. The material contained in this document is for general information purposes only. This material is not intended as an offer or a solicitation for the purchase and/or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. Nothing contained in this material is intended to constitute legal, tax, securities, financial or investment advice, nor an opinion regarding the appropriateness of any investment. Research Affiliates, LLC, is an investment adviser registered under the Investment Advisers Act of 1940 with the U.S. Securities and Exchange Commission (SEC).

SHANE SHEPHERD, Vice President, Head of Fixed Income Research,  Research Affiliates, LLC

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