Those indexes use company fundamentals: book value, sales, profits and dividends, instead of a company's market cap, to determine the weighting of companies in the index. This gives the index a slight "value tilt," Arnott says; while cap weighted indexes have a slight growth tilt. And obviously, it is more like active management in the sense that the metrics it uses are familiar to devotees of fundamental research for actively-managed equity funds.
Cap-weighted indexes reward companies that have higher stock prices by overweighting them in the index, but that is bases strictly on price, not fundamental measures, it penalizes investors over the long term, in effect, as they buy more of the companies with the higher market capitalization. "The more expensive the stock is, the more you own. If the stock doubles you own twice as much," he explains. Hearing this, an investor would ask herself: is there a better beta than cap-weighted beta?
Fundamentally-weighted indexes are now being applied to bond funds. The first bond fund to use a fundamental index as its base is an ETF: PowerShares High Yield Corporate Bond Portfolio (PHB). That fund was cap-weighted until earlier this month. The ETF will now track Research Affiliates' RAFI High Yield Bond Index--see a related article.
Arnott sat down to talk with WealthManagerWeb.com Editor in Chief Kate McBride in New York on August 10.
McBride: You just launched a fundamental index bond fund, maybe we could start with that?
Arnott: The notion of fundamental indexing makes so much intuitive sense in stocks and even more so in bonds. In stocks, with cap weighting, the more expensive the stock is, the more you own. If the stock doubles you own twice as much. That intuitively doesn't make sense. A core principle of successful investing is that you want to own more of what you think will perform better. So, is cap weighting tacitly saying that the outlook has improved after a stock doubled than before?
McBride: It looks that way, yes.
Arnott: Tacitly yes. To turn attention to the bond side: If I'm a borrower and you're a bondholder, you're lending to me. If I decide I want to double my borrowing, as a bondholder with a cap-weighted bond index, you're going to lend more to me just because I want more money.
McBride: Not based on the fundamentals of whether you deserve more money...
Arnott: Or [if I] can handle the debt service. So when you apply a fundamental index on the bond side you weight companies on their financial resources, on the size of their business--not with the size of their debt burden.
We hear a lot of controversy in sovereign debt about Greek debt. Less so about German and French debt--but worries that, they've got a lot of debt and does it make sense for them to backstop the Greeks? You never hear about Australian debt--because there isn't much. Which would you rather lend to: Australia or Greece?
McBride: I think the answer is clear.
Arnott: Yup. Now, in an efficient market you're going to get paid more to lend to Greece, exactly in proportion to the incremental risk. So if bond markets are perfectly efficient, okay, lend more to Greece--if they borrow more, lend more still. As long as there's that nice linkage between the return you're going to earn and the risk that you're taking.
Australian and Greek debt a year ago had very similar yields but Australian debt, relative to GDP a year ago, was one-sixth as large as Greece--so, wouldn't it make a lot more sense to GDP-weight your debt? It certainly would, but GDP isn't the only measure of how solvent a country is.
There are four broad factors of production. There's capital--GDP is a decent proxy for that. There's labor--population works fine. There's resources--the size of a country can be a crude, rough proxy for resources. There's energy--the energy that a country uses and puts into its production capacity is a perfectly good measure of that. You could average those four measures and get a very crude measure of how much debt a country could comfortably support. So for a sovereign debt portfolio you could do fundamental index as well.
McBride: Ah. Now, the fund you just came out with is not sovereign, it's corporate, right?
Arnott: Correct--and on the corporate side you want to wonder how big is the company's business? So you've got sales, you've got profits, you've got--for fundamental index in stocks--dividends. Well, heck, that also matters in bonds, because if a company pays its dividends, you're more likely to get paid on the bond side than if it's given up on dividends. Instead of book value why don't we look at gross assets--because a stockholder has a call on the book value of a company; the bondholder has a call on the total assets. If you use those four measures for corporates, you have a fundamentally-weighted bond index.
What's neat about applying this in the bond arena is whether you're talking corporates or sovereigns you're not going to be drawn into lending more to a company or a country simply because it's borrowing more--and with cap-weighting, you are.
If you use a fundamental approach based on how big is the country's economy, how big is the company's business, then the bigger the economy, the more you're willing to lend; the bigger the company the more you're willing to lend. But it's proportional to the size of the company or country, not proportional to their appetite for borrowing.
You go back historically and of course you get a higher quality portfolio. Cap-weighting will load up on the biggest debtors. Makes no sense but it will. You also have [with fundamental indexing] a less risky, less volatile portfolio...because you don't have credit-spread volatility to the same extent. With lower risk and higher quality you ought to get a lower return. You don't--which tells me that the bond markets are not efficient. If you have an inefficient market that prices Greek and Australian debt the same a year ago, despite a 6:1 bond-scale-to-GDP ratio, that doesn't make sense--and yet, that's what it was.
What we're looking at is, in the fundamental index in the bond arena you wind up with something that intuitively makes sense, lowers your risk, raises your quality and boosts returns. How much? Surprising amounts. If you're looking at high-yield it adds about 4% per year, compounded.
McBride: Going back how long?
Arnott: Thirteen years. With emerging market debt, it adds about 2%, compounded, also for 13 years, but it does it with such sharply lower risk that the risk-adjusted value added is also 4%.
To me the big shock, because almost all of these bonds are AAA, is the developed economy's sovereign debt market going back 12 years, which is as far back as we could get good data on that; it adds 90 bps.
McBride: You're talking about sovereigns now?
McBride: And you're saying they're almost all AAA?
Arnott: On a size-weighted basis they're AAA.
McBride: Why going back 13 years--that would be back to the Russian Crisis--is that the reason?Arnott: The sovereign debt markets in emerging markets--we took it back including the Russian Crisis, but it doesn't make that much difference.
McBride: But was that the reason for 13 years? Or was it something else?
Arnott: It was just data availability--we always take our tests as far back as we can get good data. When you look at this applied in the bond arena--I see the PowerShares adoption of this in the bond arena as opening the floodgates. The appetite for bond funds that load up on companies or countries merely because they're more in debt is so alien to any common sense that, I think, as people realize that there's an alternative available that weights companies or countries according to their ability to pay the debt, you're going to see a flood of interest.
I would go so far as to say it won't surprise me if 10 years from now fundamental index for bonds is even bigger than fundamental index for stocks.
McBride: Do you worry about supply though in an inefficient market like bonds?
Arnott: Ah, it's a huge market. Right now the PHB [the PowerShares High Yield Corporate Bond Fund] is $250 million. So there's finally a quarter-billion dollars of retail money invested in fundamental index for bonds. How big is the aggregate high yield bond market? For high yield, the total size of the market in the U.S. is barely under $1 trillion. Once we get out in the sovereign debt arena, sovereign debt worldwide is on the order of $39 trillion.
McBride: Is there a sovereign (fundamental indexed) fund scheduled now.
Arnott: Nothing is scheduled--it's on my wish list. May be a product in the next year or two.
Find out more about how fundamental indexes work:
Comments? Please send them to firstname.lastname@example.org. Kate McBride is editor in chief of Wealth Manager and a member of The Committee for the Fiduciary Standard.