Traditional bond indices are inherently flawed because investors will have the largest exposure to those issuers that have the largest amount of debt and this could leave them exposed to unnecessary high risks, according to US-based provider of asset allocation strategies Research Affiliates.
"Australia has three times the GDP [gross domestic product] of Greece, while Greece has three times the public debt in Australia," Research Affiliates chairman and founder Robert Arnott said.
"Why on earth should we want to have three times as much debt outstanding to Greece as to Australia, instead of the other way around?"
Research Affiliates has developed a different methodology for constructing indices, which it calls Fundamental Index.
It has recently launched a series of bond index products in the US based on this methodology, in partnership with bond index provider Ryan ALM.
The resulting investments have a higher concentration in high quality credit investments, while it also has more investments in short duration bonds.
"A fundamental index for sovereign debt reverses the problem," Arnott said. "Empirically, going back 13 years, it outperforms the sovereign debt index by over 100 basis points per year."
The company also provides indices on corporate bonds. "In high-yield bonds, we find a historically fundamental index adds 300 basis points per year with a lower duration and higher quality portfolio," he said.
Arnott also said the valuation of emerging market debt is out of skew.
"We find that the debt cover ratios in emerging markets are ten times as good as debt cover ratios in the G5," he said.
"And yet we find in the yields that there is a 3 per cent risk premium for buying emerging markets debt. Maybe it should be the other way. Maybe 15 years from now it will be the other way," he said.
He dismissed the idea that risk premiums of emerging market debt are an appropriate reflection of the stability of these countries.
"In the last decade you had two governments in Argentina and Ecuador abrogate, but you also had one developed economy that is doing a pocket abrogate through its neighbours - Greece," he said.
"Are [emerging markets] really more dangerous? I don't think so."
In Australia, Research Affiliates has a partnership with Colonial First State through Realindex Investments, which makes use of the RAFI index methodology.
