Bloomberg recently did a profile of Rob Arnott, the father of fundamental indexing.
Arnott, whose Research Affiliates Fundamental Index, or RAFI, provided the foundation for the first ETF based on an fundamental index, the PowerShares FTSE RAFI US 1000 Portfolio (PRF) and others, is now working on making fundamental indexes for bonds.
Instead of valuing stocks based on price, as in a market-cap weighted index like the S&P 500, the fundamental index uses fundamental metrics such as cash flow, book value, sales and dividends to determine a companies valuation.
According to Bloomberg, the PowerShares FTSE RAFI US 1000 Portfolio posted annualized returns of 5.3% from its inception on Dec. 19, 2005, through May 9, beating the 3.2% return of the Vanguard 500 Index Fund, which tracks the S&P 500.
The new bond indexes will measure a borrower’s health, such as GDP, assets available to service debt, a nation’s land mass and energy consumption. PowerShares last year began using Arnott’s bond index in the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB). It returned 8.9% from Aug. 2 to May 9 vs. the 11.7% gain in the SPDR Barclays Capital High Yield Bond ETF (JNK). Let’s see how it does now that junk bonds appear to be peaking.