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Research Affiliates, Citi bring fundamental indexation to global bonds

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EUROPE - Research Affiliates has teamed up with Citi to bring the fundamental indexation process it pioneered in equities to the global bond markets.

A new series of indices launched on 23 January to join existing indices of US investment grade and high-yield bonds that Research Affiliates constructed in partnership with US asset-liability management firm Ryan ALM, which already support a number of investable products run by affiliates.

Michael Larsen, head of affiliate relations at Research Affiliates, told IPE: “Citi met the requirement of excellent experience in global fixed income.”

The new launches include a Sovereign Developed Bond series, a Sovereign Emerging Markets Local Currency Bond series and a Corporate Bond series.

Research Affiliates’ fundamental equity indices (RAFI) rank stocks on the basis of four fundamental factors, which are equal-weighted: five-year trailing sales, cash flow, book value and dividend.

The corporate bond indices follow the equity indices by ranking issuers by sales, cash flow, dividends and book value - but book value of assets is used to reflect the contingent claims enjoyed by bondholders over shareholders.

Similarly, the sovereign bond indices rank issuers according to their five-year average PPP-weighted GDP, population, land area and energy consumption.

Both series rebalance annually, and bond index rules - such as including new issues - are met each month.

Master indices include all issues from the qualifying countries and companies, but a series of liquid indices, designed to be more investable, select the most liquid on-the-run bonds from each country or company to replicate the duration of outstanding issuance.

Larsen said one asset manager was already going through the fund filing process, with a product referencing the developed Continental European corporates index.
 
“We first embarked on research into bonds in response to criticism that our RAFI equity indices were a simple value package,” he said.

“We felt that if we could demonstrate the efficacy of a fundamentally weighted approach - which is just a rebalancing strategy around stable anchors - in another asset class than equities, we could respond to the claim that the process is simply about value.”

Chris Brightman, Research Affiliates’ head of investment management, added: “No one argues that there is a value effect in bonds, but the process works just as well.

“The volatility of bonds is smaller, so the magnitude of the returns in excess of cap-weighted indices is a little less, but you still get a nice healthy return to rebalancing to an anchor weight as you do in equities.”

Brightman stresses that Research Affiliates makes no claim that its ranking of issuers is in any way ‘right’ or ‘better than’ indices that weight in the traditional way, by outstanding debt, making the point that it is the rebalancing process that generates excess return, in a form of volatility capture.

The stability of the fundamental factors employed simply make for a steadier ‘anchor’ weighting around which rebalancing can be implemented.

But it is also more than just a statistical process. GDP is meant to measure capital; population, the labour force; land area stands as a proxy for natural resources; and energy consumption represents productivity.

Shane Shepherd, head of fixed income research at Research Affiliates, said: “The factors are factors of production and therefore a broad measure of, or proxy for, a country’s economic size in different dimensions.

“If you were to cap-weight global debt issuance, your index would have almost everything in the developed markets. And yet the developed world is only 60% of global GDP and only 20% of the global population - both of which are indicators of future economic potential.”

Larsen added: “If you equal-weight, for example, that’s fine, but you’re not representing anything related to the asset class. We want relatively low tracking error and relatively high correlation to the returns from the asset class.”

Nonetheless, despite this, and a restriction on the ratio of market-cap weight to fundamental weight of 10 times, the top-five issuers in the Citi RAFI Sovereign Bond index can look quite different from a cap-weighted equivalent.

The Citi RAFI top five would exclude France, for example, which would be a 6.39% weight and a top-three position in the cap-weighted index.

And Japan, the top position in the cap-weighted index at 32.93%, falls to second place and an 8.9% weight in the Citi RAFI index.

Shepherd said these kind of results demonstrate why the fundamental-indexation process, which breaks the link between weighting and price, actually makes even mores sense in bonds than in equities.

“It shouldn’t matter that Japan has a 200% debt-to-GDP ratio or a 400% ratio - as long as I get a yield commensurate with the risk that that presents,” said Shepherd.

“But I don’t. The yield doesn’t seem to want to take any of these things into account - until all of a sudden it decides that it should, and you get a spike.”

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