First he convinced some of us that cap-weighted indexing doesn’t work. Now Rob Arnott, the founder of Research Affiliates Fundamental Indexing (RAFI), is back with more bombshells – that the equity risk premium, as we came to know it, is gone and not hurrying back; and that emerging market debt is “objectively a better credit risk” than US Treasuries, at a higher yield to boot. Combine these two controversial thoughts, and it’s no surprise to learn that Arnott has been turning his attention to fixed income, with RAFI recently launching a bond business.
Research Affiliates has sought to reshape global sovereign fixed interest benchmarks like it did traditional equity benchmarks, where it ignored price in favour of ranking companies based on their sales, book value, dividends, earnings and number of employees. According to Arnott, established benchmarks which weight sovereign bonds according to the amount on issue are over-representing the countries least able to service their debts. “Bond investors are lenders. Why should we deliberately choose to lend more to those who are most deeply in debt?” he asks, echoing sentiments in a recent note to RAFI investors entitled ‘Debt Be Not Proud’. Arnott’s team has come up with a way of measuring a sovereign’s capacity to service its debt, which compares the level of that outstanding debt to the country’s economic size. RAFI measures economic size using four factors: gross domestic product, population (as a simple gauge of labour force size), land mass (as an even simpler gauge of its access to resources), and aggregate energy consumption.
The factors aren’t quite as straightforward as they sound. The square root of the land mass number was used, as Arnott explains, “to avoid grossly rewarding big, sparsely populated countries like Russia, Australia, and Canada, or penalising small, crowded countries like Hong Kong and Singapore.” He also placed a caveat on the energy consumption factor – that a country’s needs may partially be met through petroleum imports. Country weights for each of the four factors were calculated separately, then equally weighted to arrive at an overall weight within the RAFI sovereign bond index. Most of the countries with the best debt-burden-to-economic-size ratio, and thus most able to service their debts, were in the emerging markets. He said the reversal of market weights to RAFI weights would be even more pronounced if the benchmark were able to include debt that was not publicly traded, such as that of government-sponsored enterprises like Fannie Mae, state and local debt, off-balance sheet debt and unfunded entitlements – some of which Arnott said could be very large, particularly in the case of the US.