Are traditional bond index funds flawed?
A new bond ETF from Invesco PowerShares Capital Management will completely bypass conventional bond index strategies with a fundamental approach. The newly launched PowerShares Fundamental Emerging Markets Local Debt Portfolio (PFEM) is designed to provide investors a fundamentals-weighted exposure to emerging market sovereign debt denominated in local currencies.
Traditional bond indexes generally use some form of market-cap weighting where constituent weights are a function of both the amount of debt issued and the debt’s current price. This approach can result in greater weights being assigned to issuers that have issued more debt. In contrast, the fundamental index approach developed by Research Affiliates weights bonds based on each country’s economic footprint, resulting in a portfolio that is correlated to a country’s debt service capacity.
“Weighting by fundamentals gives higher portfolio weights to issuers with lower leverage and better debt service capacity, resulting in generally lower credit risk compared to the cap-weight benchmark,” said Shane Shepherd, senior vice president and head of fixed-income research at Research Affiliates. “In addition, a regular rebalance back to fundamental weights takes advantage of potential market inefficiencies in credit spreads by buying cheaper bonds and selling more expensive ones,” Shepherd said.
PFEM is linked to the Citi RAFI Bonds Sovereign Emerging Markets Extended Local Currency Index, which is composed of a portfolio of bonds issued by the national governments of 18 emerging market countries, all in the respective local currency.