Research Affiliates’ Robert Arnott Talks Bond Index Funds

From Institutional Investor:

Traditional bond index funds have an important flaw, says Robert Arnott, chairman and CEO of Research Affiliates, an investment firm based in Newport Beach, California. The indexes are cap-weighted. Under the system, more assets go to the issuers that are most heavily indebted. To provide a better alternative, Arnott is pioneering fundamental index funds, which weight bond issuers according to their ability to service debt. Research Affiliates now maintains RAFI benchmarks that track such bond sectors as investment-grade corporate, high yield, and emerging markets. Two ETFs follow the RAFI benchmarks: PowerShares Fundamental High Yield Corporate Bond (PHB) and PowerShares Fundamental Investment Grade Corporate Bond (PFIG). Arnott tells Institutional Investor contributor Stan Luxenberg that the new benchmarks can help to lower risk.

1. What is wrong with traditional benchmarks, such as the Barclays Capital U.S. Aggregate Bond index?
The Barclays index has a big percentage of its assets in U.S. Treasuries. As the government issues more debt, funds that track the benchmark must invest more in Treasuries. That just doesn’t make sense. Why do you want to lend more to the companies or countries that are most deeply in debt? With fundamental funds, we lend to borrowers in proportion to their ability to service debt. For corporate bonds, we give more weight to issuers with greater sales, dividends, and other indicators. Those are crude measures of debt service capacity. But they provide some guidance. If a company can still afford to pay dividends, then it certainly can pay the interest on its bonds....MORE