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A prominent figure in the exchange traded fund world describes a RAFI fundamental index evolution, which will help achieve greater returns at lower risks. However, there is a caveat. ETF traders will have to see this slow change over the next 10 years.

Olivier Ludwig for IndexUniverse asked Rob Arnott, founder of Research Affiliates and the Father of Fundamental Indexing, about his thoughts on the future of ETFs. Arnott sees that indexes in the bond ETF market will start to shift more toward weighting bonds according to an issuer’s capacity to service debt instead of the current weighting to the size of the issuer’s debt.

Emerging markets account for 37% of global GDP but they only make up 10% of world sovereign bond debt, says Arnott. RAFI for bonds shows investors that one is better off weighting according to capacity to service instead of weighting according to the size of the debt. The logic behind this is that developed countries are heavily debt ridden while emerging markets are not, but emerging markets are unfairly attached with a higher risk premium.

  • iShares JP Morgan USD Emerging Markets Bond Fund (NYSEArca: EMB): The top countries are Russia, Brazil, Mexico, Turkey and the Philippines; yields 4.83%.
  • PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY): The top countries include Bulgaria, Uruguay, Russia, Vietnam, Turkey and Indonesia; yields 5.57%.
  • WisdomTree Emerging Markets Local Debt (NYSEArca: ELD): Top countries include Malaysia, Brazil, Mexico, Indonesia, Thailand and South Africa.
  • Market Vectors Emerging Market Bond ETF (NYSEArca: EMLC): Top countries include Thailand, Poland, Turkey, Hungary and Malaysia; yields 6.45%.

Arnott also describes a RAFI for sovereign debt, which weights the country according to the size of the economy, the size of the country and size of its debt-service capacity. Simple intuition would dictate that lending to countries with little debt is safe while those with heavy debt burdens are left with less.

  • SPDR Barclays Capital International Treasury Bond (NYSEArca: BWX): Yield to maturity is 2.8%; holds Italy (11.3%), Germany (10.2%), United Kingdom (4.6%), France (4.6%), Spain (4.4%), Netherlands (4.4%), Greece (4.2%) and Austria (3.6%)
  • SPDR Barclays Cap Short-Term International Treasury Bond (NYSEArca: BWZ): Yield to maturity is 1.6%; holds Italy (11.1%), Germany (11%), United Kingdom (4.6%), Spain (4.4%), France (4.2%), Netherlands (4.2%) and Greece (3.4%)
  • iShares S&P/Citi Intl Treasury Bond (NYSEArca: IGOV): Yield to maturity is 2.8%; holds Italy (8.8%), Germany (8.2%), France (7.4%), United Kingdom (4.9%), Spain (4.7%), Netherlands (4.7%) and Austria (4.2%)
  • iShares S&P/Citi 1-3 Yr International Treasury Bond (NYSEArca: ISHG): Yield to maturity is 2%; holds Germany (10%), Italy (7.5%), France (6.3%), United Kingdom (4.7%), Netherlands (4.5%), Spain (4.3%) and Greece (4.3%)

Some worry about the notion that the introduction of bond ETFs are helping to price bonds, but Arnott believes that the price discovery mechanism in ETFs help the overall market, along with providing greater liquidity and allowing more investors to control their investments.

Max Chen contributed to this article.

Source: A Slow Evolution in Indexing for Sovereign Debt ETFs