There is a battle being waged over the best way to index fixed income. Supporters of alternative indexing claim that in this era of sovereign debt crises the traditional form of indexing gives too much weight to overly indebted countries, while those who favor the traditional cap weighted method claim that efficiencies in the market are strong enough to adjust to fundamental factors.

Like the S&P 500, traditional bond indexes like the Barclays Aggregate Bond Index are cap weighted. For stocks this means that the companies that have the highest market cap are given the biggest weights in the index. Bond indexes are based on the same metric, but use debt values instead of equity values. In an example of a corporate bond index, this results in the company that issues the most debt having the largest weight in the index. To avoid that, alternative indexes give weights to index members based on criteria like debt ratios, instead of market cap.

The current interest in alternative bond indexes can probably be attributed to Europe, where burdensome debt levels and struggling economies are making it difficult, and in a few cases impossible, for some countries to pay their debts. Alternative bond indexes that weight members based on metrics like lowest debt to GDP ratio or largest population end up with a different makeup than cap weighted indexes. For example, a European government bond fund might allocate money away from issuers with higher debt loads relative to GDP such as countries like Greece, Spain and Portugal, and give more weight to issuers with lower debt/GPD ratios like Germany. That one example may make alternative indexing seem pretty attractive, but hold on.

In reality, factors like debt/GDP ratio, willingness to pay back creditors, demographic trends, inflation and currency stability all weigh in at issuance and continue to have an effect as the bonds trade in the secondary market. Reweighting indexes toward issuers with better fundamentals may seem like a better way to invest, and results for that strategy could be better over specific time periods, but there is no evidence that over the long run it provides better risk adjusted returns. Using alternative factors to determine weights for an index could actually skew the index toward more risk than cap weighting, which contradicts the marketing for the indexes and the products that track them.

Traditional index strategies like cap weighted usually dictate some minimal credit quality based on either rating or yield spread. This creates limits to what they can include. For example the Barclays US Aggregate Bond Index tracks only the investment grade bond market in the US. A company with dangerously high amounts of leverage would naturally be charged higher interest rates by the market and wouldn’t likely carry an investment grade rating, so it is excluded from the index to begin with.

The backbone of any passive strategy is that markets are efficient enough to make it very hard for an individual investor to gain an edge. In my opinion, these alternative strategies are more of a departure from traditional indexing than they claim to be and are much more like making active calls and forecasting than investing passively.

Have a great weekend.