A Comparison of Municipal Bond Index Weighting Schemes
Posted: 24 Mar 2015
Date Written: January 1, 2010
Valuation-indifferent weighting has gained significant interest as a strategy for creating alternative indexes. The weighting scheme has empirical support for equities, investment-grade, high-yield, and emerging market bonds. Portfolio weights formed based on prices or market capitalizations tend to be positively correlated with pricing errors. In contrast, valuation-indifferent weighting or fundamental weighting schemes do not exhibit this positive correlation between portfolio weights and pricing errors. As a result, a price-weighted portfolio would have greater portfolio weights committed to overvalued equities versus a non-price-weighted portfolio, which results in sub-optimal performance. In this study, we apply the same concept of a valuation-indifferent weighting to municipal bonds and show that it outperforms traditional weighted benchmarks. The degree of outperformance is higher during bear markets, high volatility, and falling interest rate periods. Alphas from three to five factors bond pricing model of the returns of fundamental index muni remain significant.
Keywords: Municipal Bonds; Municipal Bond Index; Passive Investing; Indexing
JEL Classification: G11, H70
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