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1 January 2017 Financial Analysts Journal

Bonds: Getting to the Fundamentals (Summary)

  1. Phil Davis

This In Practice piece gives a practitioner’s perspective on the article “Fundamental Indexing in Global Bond Markets: The Risk Exposure Explains It All,” by Lidia Bolla, CFA, published in the First Quarter 2017 issue of the Financial Analysts Journal.

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What’s the Investment Issue?

Market-value-weighted indexes are the staple of passive investing, which is remorselessly increasing its share of global investment assets. But passive investing has been questioned by some investors, who note that in passive indexing, risks are increasingly concentrated. These investors are concerned about the systematic shift of market-value-weighted stock indexes towards companies with rising market capitalizations and of bond indexes towards issuers with an increasing volume of outstanding debt.

Fundamental indexing, by which companies are weighted based on financial-valuation metrics, such as earnings, revenue, assets, and book value, has emerged as a credible alternative to market-value-weighted indexes. A considerable body of research has shown that it can help deliver superior returns for equity investors.

There is comparatively little research on fundamental indexing approaches in fixed-income markets. The author sought to find out whether fundamental indexing of government bonds of developed countries generates more attractive returns than market-value-weighted indexing and, if so, why.

How Does the Author Tackle the Issue?

The author investigated whether factor-based indexing of fixed income behaves like factor-based indexing of equities and more deeply analysed the outperformance of fundamentally indexed strategies. Some have criticized the outperformance of fundamentally weighted equity indexing as having its roots in a value tilt, so it is possible that the outperformance of fundamentally weighted fixed-income indexes might be caused by specific tilts too.

As an alternative to the traditional value-weighted methodology for creating bond indexes, the author created a methodology based on four fundamental factors. These factors have been tested to some extent in previous research into fundamental indexation, and she sought to analyse them in more depth. They are as follows:

1. GDP in US dollars, as a proxy for the size of a country’s economy

2. The size of the population, as a proxy for the size of the labour force

3. The square root of the land area, as a proxy for the country’s resource richness

4. Energy usage, as a proxy for technological progress

The author then constructed five fundamentally weighted indexes, composed of government bonds from 26 countries spanning every region of the world. She created a standalone index from each of the four fundamental factors and also combined the factors into a composite index. The performance of each of these five indexes was compared with the performance of a market-value-weighted index of government bonds. The author also tested whether outperformance exists in subperiods and different market environments.

Finally, the study applied attribution analysis to find the extent to which the performance of each index could be explained by nine well-recognised risk factors: the market return, Fama and French’s size and book-to-market factors, and six fixed-income factors—term, duration, default, convexity, liquidity, and carry. Many of these factors have not been assessed in prior research into the fundamental indexing of bonds.

What Are the Findings?

A fundamental indexing approach leads to significantly higher performance than a market-value-weighted index of government bonds, which reflects higher exposures to a range of underlying risks. The study’s results show outperformance by all four fundamentally weighted indexes as well as the composite index.

Whereas the market-value-weighted benchmark earns an average annualised return of 5.78% over the period of the study (1960–2013), the composite index outperforms it by 0.72 percentage points (pps) a year and an equal-weighted index outperforms by 0.98 pps. The land-area-weighted index does particularly well, outperforming the market-value-weighted index by some 1.22 pps.

But these abnormal returns are less positive after accounting for the risk factor exposures of the five indexes. A large proportion of the active returns of the fundamentally weighted global bond indexes can be attributed to bond market characteristics. The results show significant exposures of fundamentally weighted indexes to the six fixed-income factors. For example, the best-performing index, the land-area-weighted index, has particularly high exposures to the duration and default risk factors. Across all the indexes, duration, convexity risk, and carry seem to be responsible for a substantial amount of the outperformance.

Specifically, the fixed-income risk factors increase the performance of the GDP-weighted index by 0.95 pps, of the population-weighted index by 5.01 pps, of the land-area-weighted index by 19.34 pps, of the energy-weighted index by 3.74 pps, and of an equally weighted index by 12.74 pps.

What Are the Implications for Investors and Investment Professionals?

Outperformance uncovered in the study is due to higher exposures to underlying risks, not due to the factor indexing itself. But the author believes that by using factor indexing and understanding the underlying risks better, valuation-indifferent indexing strategies should be seen as a valid alternative to market-value-weighted indexes—with their known issues.

She also thinks that growth in passive investing will continue unabated, meaning that future studies of the performance of various bond-indexing methodologies are essential for investors to manage their exposures and maximise risk-adjusted returns from their fixed-income portfolios.

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