In most bond indexes, the biggest debtors (either corporations or countries) have the largest weightings. To some investors, that sounds a bit foolish.
“With a fundamental index, you’re turning that on its head,” says Joseph Becker, senior fixed and equity income product strategist at Invesco PowerShares, which offers three fundamentally weighted bond ETFs. All three are based on methodology developed by Research Affiliates.
For the corporate bond funds, both investment-grade (PFIG) and high-yield (PHB), the weightings are based on a company’s sales, dividends, cash flow and book value. For the local currency emerging market bond fund (PFEM), a country’s weighting is based on GDP, land mass (adjusted so that a huge country like Russia doesn’t overwhelm the weighting), population and energy consumption. “Energy consumption is meant to be a proxy for technological advancement and productivity,” says Becker.
“I think the idea behind fundamentally weighted fixed-income funds makes a lot of sense,” says Rusty Vanneman, chief investment officer of CLS Investments, a third-party money manager in Omaha that works with fee-only advisors.
Even so, Vanneman says that such funds constitute less than 10% of fixed-income assets that his firm manages. He cites two main reasons: Many long-held taxable portfolios would give up much to the IRS if switched now. And traditionally weighted funds are generally larger, meaning they have tighter spreads.
But Vanneman sees fundamentally weighted fixed income as the future. “I would imagine that our position in fundamentally weighted fixed income is only going to increase in the years ahead,” he adds.
While backtested results showed outperformance of fundamentally weighted bond portfolios, real world data paint a mixed picture. In the case of PHB, which began to track the Research Affiliates index in August 2010, it has trailed the more conventional Barclays U.S. Corporate High Yield Index over the past three years.
“We attribute that primarily to the credit environment,” says Becker. Over the past few years, rates have been so low that investors have been stretching for returns. “You could go out on the yield curve or you could go down the credit spectrum,” he says. “The junkier something has been, the better it’s done.”
By design, Invesco's fundamental high yield corporate bond fund (PHB) avoids lower quality junk bonds.
Within the high-yield category, says Vanneman, “It’s almost like each one of those credit ratings is a whole different asset class.” That’s another reason he likes fundamental weighting: “The higher quality high-yield bonds, over time, tend to provide the best risk-adjusted performance,” he says.
Joseph Lisanti, a Financial Planning contributing writer in New York, is a former editor-in-chief of Standard & Poor’s weekly investment advisory newsletter, The Outlook.