, distinguishing itself from other products in the Corporate Bonds ETFdb Category by the weighting methodology employed by the underlying index.
PFIG will seek to replicate the RAFI Investment Grade Corporate Bond Index, a benchmark that utilizes the fundamental weighting methodology pioneered by Research Affiliates. Most fixed income indexes–including many of those to which the most popular bond ETFs are linked–assign weightings based on the amount of debt issued and the price of the individual securities. That approach can potentially have some less-than-optimal impacts on the composition of any related ETFs. First, there is a tendency to assign the largest weightings to the largest issuers of debt–a group likely to include companies with the most significant debt burdens. Second, similar to a widely-cited drawback in the equity arena, this approach will tend to overweight overvalued debt and underweight undervalued securities.
PFIG’s index assigns weightings based on an issuer’s ability to service debt; specifically, the methodology utilizes four fundamental measures of firm size, including book value, sales, dividends, and cash flow. The result is an index that breaks the link between debt burden and weighting assigned, an approach that may have appeal to investors who have been hesitant to utilize ETFs as a means of accessing the fixed income asset class [see Are Bond ETFs Broken?]
“The Fundamental Index methodology applies to bonds as well as stocks. In a cap-weighted bond index fund, investors are making their biggest bets on the biggest bond issuers,” said Rob Arnott, chairman and CEO of Research Affiliates, LLC. “Why would you make your biggest allocation to the largest debtors?”
PFIG vs. CBND
PowerShares had previously converted a product offering exposure to junk bonds (NYSE:PHB) to a fundamentally-weighted RAFI index; PFIG becomes the second fixed income ETF in the company’s suite of RAFI bond ETFs. The success of the junk bond fund highlights the potential difference the weighting methodology can make; PHB is the best performing ETF in the High Yield Bonds ETFdb Category, outpacing ultra popular funds such as (NYSE:HYG) and (NYSE:JNK) by a wide margin.
Earlier this year, State Street also debuted an investment grade corporate bond fund designed to steer clear of the market cap weighting methodology that dominates both the stock and bond ETF spaces. The SPDR Barclays Capital Issuer Scored Corporate Bond ETF (NYSE:CBND) has some general similarities to PFIG, but implements the fundamental weighting in a slightly different manner.
The index to which CBND is linked scores issuers of investment grade corporate debt on three metrics: return on assets (net income / total assets), interest coverage (EBIT / interest expense) and current ratio (current assets / current liabilities). The general idea is the same; CBND is designed to give greater allocations to issuers with the strongest ability to service outstanding debt obligations. But the exact metrics evaluated by the two companies vary slightly.
Market cap weighting is the methodology of choice behind many of the most popular ETFs on the market, but the ETF industry has also advanced the acceptance of several alternative strategies. In addition to the RAFI approach, which is behind products from PowerShares and ProShares, there are ETFs linked to indexes that use equal weighting, dividend weighting, revenue weighting, earnings weighting, and other approaches. While the choice of weighting methodology may seem like a relatively minor detail, that selection can actually have a material impact on bottom line return and volatility [see For ETF Investors, The Details Matter].
Written By Michael Johnston From ETF Database Disclosure: No positions at time of writing.
ETF Database is committed to giving our audience, consisting of both active traders and buy-and-hold investors, information that, to our knowledge, is truthful and non-biased. [For more ETF insights, sign up for our free ETF newsletter or try a free seven day trial of ETFdb Pro.]