Applying Valuation-Indifferent Indexing to Fixed Income

Abstract:     
In historical testing, valuation-indifferent indexing as applied to U.S. and global equities has produced statistically significant and economically large outperformance when compared with traditional capitalization-weighted benchmarks (Arnott, Hsu, and Moore [2005], Tamura and Shimizu [2005] and Hsu and Campollo [2006]). In this paper, we apply the method to U.S. investment-grade corporate bonds, U.S. high-yield bonds, and hard-currency emerging market bonds. We find that fixed-income indexes constructed using valuation-indifferent indexing outperform the corresponding cap-weighted benchmarks.

We also find that the outperformance is higher for markets in which we might typically expect more inefficiencies and greater volatilities. Both findings are consistent with the empirical evidence found in the equity applications of valuation-indifferent indexing, as well as the proposed theoretical rationale for these results.

Keywords: Fundamental Index, Valuation-Indifferent Index, Bond Index

JEL Classifications: G12, G14

Working Paper Series