Arnott, Citi Launch Sovereign Bond Indexes

Rob Arnott’s Research Affiliates and CitiGroup this week rolled out a roster of bond indexes that apply Arnott’s fundamentally weighted index methodology known as RAFI to the sovereign debt space.

The Citi RAFI Bond Index Series minimizes exposure to “aging and debt-laden” economies such as the United States and Japan, while focusing on resource-rich, younger markets such as Australia and Canada. The indexes weight countries by their “economic footprint,” the Newport Beach, Calif.-based company said in a press release.

The new sovereign developed and its emerging markets counterpart indexes are a departure from most existing bond benchmarks, which typically weight securities based on market capitalization, meaning investors make their biggest best on the biggest debtors. That can be disastrous, with Greece looming as the best current example.

“Each country’s weight is calculated via an equally weighted average of four factors—gross domestic product (GDP), energy consumption, population and rescaled land area,” the company said in the release. “This methodology results in country weights that reflect each nation’s ability to service its debt, which has become a growing concern as the sovereign debt crisis evolves.”

Indeed, the issue of sovereign debt has come to the forefront in the global economy’s recovery story, as developed nations struggle with heavy debts and deficits that have cast a shadow on their capacity to fuel growth.

The RAFI benchmarks underscore a growing demand for sensible sovereign debt exposure, which to many investors has meant looking to countries relatively free of debt, primarily in the developing world.

“Mounting debt and deficits, combined with aging demographics pose a 3-D hurricane to developed nations,” Arnott said in the release. “Existing capitalization-weighted bond indices tend to overweight the largest debtors, without regard to whether they deliver a yield commensurate with the risk they are taking.”

The RAFI Difference

Arnott’s fundamentally weighted methodology has resonated with investors and is gaining more traction as a viable alternative to cap-weighted strategies, as Rob Arnott himself discussed with Managing Editor Olivier Ludwig last year.

Take the Citi RAFI Sovereign Debt Developed Markets Bond Index, for instance. It allocates 21.7 percent to the United States, with Japan coming second, at nearly 9 percent, followed by allocations to Canada, Germany and Australia hovering around the 7 percent mark.

By contrast, what the company called an “equivalent” sovereign developed-markets capitalization-weighted index would have Japan representing as much as a third of the portfolio, with the U.S. coming in second, with a 27.6 percent allocation. France, Germany and the United Kingdom would round out the top five holdings, the company said.

RAFI Index Outperformance

RAFI’s different weighting methodology would have outperformed the capitalization-weighted index over long time periods, while keeping the same duration risk, the company added.

“Over the 10-year period ending Dec. 31, 2011, the Citi RAFI index would have returned 8.6 percent on an annualized basis, compared with an equivalent market-capitalization weighted index return of 7.8 percent on simulated results,” it said.

Research Affiliates boasts more than $50 billion in assets linked to its various RAFI products, such as an extensive roster of Invesco PowerShares ETFs tied to RAFI benchmarks.

PowerShares was the first ETF provider to launch a RAFI-based fund, six years ago:the PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca:PRF - News), which has gathered $1.1 billion in assets since its 2005 inception.

Another Citi-RAFI bond index, this one focused on the developed-markets corporate bond space, will be released in the spring, the company said. All of the RAFI bond indexes are “available for licensing,” it added.


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