Financial Analysts Journal | A Publication of CFA Institute
Fundamental Indexing in
Global Bond Markets: The
Risk Exposure Explains It All
Lidia Bolla, CFA
Lidia Bolla, CFA, is managing partner at Algofin AG, St. Gallen, Switzerland.
I
To investigate the fundamental
indexing methodology, I apply it
to global government bond mar-
kets and examine its exposure
to several newly introduced risk
factors. I find that the fundamen-
tal indexing approach outper-
forms a market-value-weighted
index. However, my results show
statistically significant and eco-
nomically relevant exposures of
fundamentally weighted indexes
to the risk factors term and dura-
tion risk, default risk, convexity
risk, liquidity risk, and carry trade
risk. The increased risk exposure
explains the outperformance of
the fundamental indexing meth-
odology in government bond
markets.
CE Credits: 1
Volume 73 Number 1 © 2017 CFA Institute. All rights reserved.
Research
n recent decades, index investment strategies have been on
the rise. In particular, institutional investors have increasingly
applied a passive approach to investing. Several studies showing
an outperformance of passive strategies on a net return basis (e.g.,
Malkiel 2003) have supported the move into passive strategies.
Given that most of the major market indexes used in passive invest-
ing apply a market-capitalization-weighted approach, it follows that
the vast majority of passively invested portfolios are also market
value weighted. With the rise of passive investing, however, the
criticism of this predominant approach has increased. Market-value-
weighted indexes, for example, often exhibit risk concentrations in
a few companies or governments. The systematic shift of market-
value-weighted indexes toward companies with an increasing
market capitalization or toward governments with an increasing
volume of outstanding debt intensifies those cluster risks over
time. Following the criticism of market-cap weighting, new alterna-
tives for passive portfolio construction have evolved. Fundamental
indexing is one of the approaches that has been developed as an
alternative to market-value-weighted indexes.
Previous studies have shown that fundamental indexing
approaches seem to deliver superior returns. Attempting to fill
the gap in the literature regarding fixed-income fundamental
indexing, I analyzed fundamental indexing globally in govern-
ment bond markets and confirmed the outperformance of the
alternative indexing methodology. Contrary to previous studies
in this field, however, in my study I demonstrated empirically that
the outperformance can clearly be attributed to a deviating risk
factor exposure. In particular, I found an increased exposure to
term, duration, default, convexity, liquidity, and carry trade risk. In
practice, fundamental indexing strategies can still be a valid option
for investors looking for an alternative weighting methodology. In
fixed-income markets, for example, investors might be interested
in a substitute for market-value-weighted indexes to avoid the
101
Financial Analysts Journal | A Publication of CFA Institute
systematic shift toward countries with an increas-
ing volume of outstanding debt or a potentially
unwanted high-market-value weighting of a few
countries. In this article, however, I argue that
the performance difference between the market-
value-weighting methodology and fundamental
weighting schemes can be explained by differ-
ences in the risk exposure.
Of all the studies in the literature on alterna-
tives to passive portfolio construction, first and
foremost is Arnott, Hsu, and Moore (2005), who
introduced the fundamental indexing approach.
They weighted US equities by fundamental
factors (equity book value, gross sales, gross
dividends, gross revenue, and total employment)
and found an average annual portfolio outper-
formance of 1.97% over a period of 43 years.
Arnott and West (2006) extended the research
to regions outside the United States and found
similar results for the stock markets of 23 devel-
oped countries. Hemminki and Puttonen (2008)
and Glabadanidis, Obaydin, and Zurbruegg (2012)
confirmed the earlier results and concluded that
the outperformance is especially substantial in
times of average stock market volatility. Hsu,
Li, and Kalesnik (2010) transferred the idea to
the listed real estate market and found a yearly
outperformance of 4.0% for the US market and
2.9% for non-US markets against the respective
capital-weighted benchmarks. Several authors
have questioned the findings in the area of equity
fundamental indexing. Although Amenc, Goltz,
and Le Sourd (2009) and Chow, Hsu, Kalesnik,
and Little (2011) confirmed the earlier results,
they attributed the outperformance to a value tilt
in the fundamentally weighted equity portfolios,
concluding that fundamental indexing does not
generate abnormal returns when regressed on
Fama and French (1992) or Carhart (1997) risk
factors.
In contrast to the broad literature on equity
fundamental indexing, there is a significant lack
of research on fundamental indexing approaches
in fixed-income markets. To the best of my
knowledge, Arnott, Hsu, Li, and Shepherd (2010)
and Shepherd (2011) are the only studies that
have extended the fundamental indexing idea to
bonds in analyzing the markets for US corporate
102 cfapubs.org
bonds, US high-yield bonds, and emerging-market
government bonds. In an approach similar to
equity fundamental indexing, Arnott et al. (2010)
used the following factors in their analysis of US
bonds: cash flow, dividends, book value of assets
(instead of equities), sales, and face value of the
debt issue. In their analysis of emerging-market
bonds, they used population, the square root of
the land area, GDP, and energy consumption as
fundamentals. They found higher returns, lower
volatilities, and thus improved Sharpe ratios for
all three markets. They found an average annual
outperformance of fundamentally indexed US
corporate bonds, US high-yield bonds, and
emerging-market bonds of 0.42%, 2.60%, and
1.43%, respectively. On the basis of these
research results, Citigroup recently launched the
Citi RAFI Bond Index Series, which provides fun-
damentally weighted indexes for both developed-
and emerging-market government bonds.1
Data and Methodology
In this section, I provide an overview of the
data and methodology that I used in my study,
especially regarding return indexes and index
construction.
Return Indexes. I constructed fundamental
indexes for government bonds on the basis of
the market-value-weighted Citigroup World
Government Bond Index (CG WGBI) and the
corresponding country indexes. Table 1 provides
an overview of the countries I selected for my
analysis. I chose a global scope, analyzing 26
countries from North and Middle America, Europe,
Africa, and the Asia-Pacific region. The US gov-
ernment was the biggest issuer (30.0% of market
value as of 31 December 2014), followed by
Japan (22.8%) and several European governments
(Italy, 7.8%; France, 7.8%; Germany, 6.5%; United
Kingdom, 6.4%). I studied the period January
1991–December 2014 and based my analysis on
monthly data.2
Regarding country selection, I did not try to
replicate exactly the CG WGBI. I based the inclu-
sion date of a specific country not on the inclusion
date in the CG WGBI but, rather, on the launch
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 Fundamental Indexing in Global Bond Markets

Table 1. Overview of Country Indexes

Citigroup Index Annual Return Standard Deviation Sharpe Ratio Market Value
Launch Date since Launch since Launch since Launch (31 Dec 2014)

Australia 29 Dec 89 8.7% 11.8% 0.47 1.3%

Austria 30 Oct 92 6.2 10.3 0.33 1.3
Belgium 31 Jan 91 6.7 10.8 0.35 2.1
Canada 29 Dec 89 7.3 8.9 0.47 1.8
Denmark 29 Dec 89 7.6 10.4 0.43 0.6
Finland 31 Jan 95 6.3 10.3 0.35 0.5
France 29 Dec 89 7.4 10.5 0.41 7.8
Germany 29 Dec 89 6.5 10.5 0.33 6.5
Greece 30 Jun 00 –0.4 28.7 NA 0.0
Ireland 30 Oct 92 7.3 12.8 0.35 0.7
Italy 29 Dec 89 7.7 12.4 0.37 7.8
Japan 29 Dec 89 4.6 11.5 0.13 22.8
Malaysia 31 Jul 07 3.4 8.6 0.34 0.4
Mexico 30 Jan 04 6.2 13.6 0.35 0.9
Netherlands 29 Dec 89 6.8 10.5 0.35 2.1
New Zealand 30 Oct 92 8.9 12.5 0.48 0.2
Norway 31 Jan 95 5.4 11.1 0.25 0.2
Poland 31 Jan 00 10.0 16.3 0.50 0.5
Portugal 31 Jan 95 7.2 14.2 0.32 0.6
Singapore 30 Sep 04 5.4 7.3 0.54 0.3
South Africa 29 Apr 11 –6.1 18.9 NA 0.4
Spain 31 Jan 91 6.4 12.2 0.28 4.2
Sweden 31 Jan 91 5.9 11.7 0.26 0.4
Switzerland 29 Dec 89 6.6 11.5 0.30 0.3
United Kingdom 29 Dec 89 8.0 10.0 0.49 6.4
United States 29 Dec 89 6.2 4.4 0.71 30.0

NA = not available.
Notes: This table provides an overview of the country indexes in the CG WGBI. The statistics are based on US dollar returns and
are shown as annualized measures.

date of the country index. I included in my analysis
countries that had been excluded from the CG
WGBI because of a rating downgrade in order
to maximize the dataset and minimize turnover
within the index. As a benchmark for the funda-
mentally weighted indexes, I constructed a market-
value-weighted index with an equivalent country
selection approach. By using Citigroup’s country
indexes, I benefited from the inclusion and exclu-
sion criteria applied to the individual bonds.3
Index Construction. For the fundamental
indexing approach in government bond markets,
I used specific country characteristics in building
index weights. In my study, I focused on criti-
cally analyzing the approach proposed in prior

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Financial Analysts Journal | A Publication of CFA Institute
literature. Therefore, the fundamental factors I
used for building the index weights correspond to
the approach suggested by Arnott et al. (2010) as
well as the approach used in the Citi RAFI Bond
Index Series. I used the following fundamental fac-
tors: (1) GDP in US dollars as a proxy for the size
of a country’s economy, (2) size of the population
as a proxy for the size of the labor force, (3) square
root of the land area as a proxy for the country’s
resource richness, and (4) energy usage as a proxy
for technological progress. I obtained all factor
data from the World Bank database4 for the years
1960–2013 (yearly frequency).5
I created five fundamentally weighted fixed-income
indexes. First, I used each of the four fundamental
factors on a standalone basis and then combined
the factors into a composite index. To construct the
composite index, I weighted all four fundamental
factors equally. As a benchmark to measure the
performance of the five fundamentally weighted
indexes, I calculated an equivalent market-value-
weighted index, basing it on the same set of
countries as the fundamentally weighted indexes
but using the market value of the issuer countries’
bonds as the weighting factor. I also constructed an
equally weighted index as an additional valuation-
indifferent index, which equally weighted the issuer
countries of the bond universe.
I rebalanced the indexes with a yearly frequency
on 1 January of every year. Because I obtained the
fundamental factor data on a yearly basis, imple-
menting a higher rebalancing frequency would not
have been constructive. I used five-year rolling
averages of each country’s fundamental factors
for building the index weights. This approach was
intended to create stable indexes and thus reduce
the yearly rebalancing turnover. I based the analy-
sis on US dollar returns, thus showing the indexes
in an unhedged setting. I included transaction
costs in the analysis for all indexes by assuming a
flat fee of 10 bps for every purchase and sale.
The country indexes were launched on different
dates. I started the analysis in January 1991 with
a subset containing the 11 country indexes that
had been launched up to that point and included
the other countries at the rebalancing date on
which the first data points were available. All the
104 cfapubs.org
indexes—the fundamentally weighted indexes,
the market-value-weighted index, and the equally
weighted index—have the same set of countries
included at every point in time.
Figure 1 depicts the country weightings of all the
indexes over the period analyzed; Table 2 high-
lights the factor weights at specific dates. Because
countries were included at the rebalancing date
on which the first data points were available, the
indexes grew steadily in terms of the number of
countries included. By comparing Table 2 with
Table 1, we can observe, for example, that the fac-
tor land area leads to a substantial deviation from
the market-value-weighting approach by shifting
the weights toward such countries as Australia
and Canada. But the factors GDP and energy
usage increase the weighting factor of the United
States even more. Countries that previously had
a sub-investment-grade rating and then received
an investment-grade rating during the observa-
tion period (e.g., Mexico and Malaysia) do not yet
exhibit large market values and thus have only a
small weight in the market-value-weighted index.
Owing to Mexico’s relatively large population and
land area, it receives a higher share in some of the
fundamentally weighted indexes.
I conducted a range of robustness checks to assess
the significance of the methodology applied. First,
I performed the entire analysis using hedged
versions of the indexes. I constructed the hedged
indexes by calculating local currency returns
and by taking the interest rate differentials into
account as hedging costs (the results are reported
later in the article). I amended the size of the roll-
ing window for building the fundamental factor
averages. I found that the results remain robust
to the rolling-window size.6 Finally, I changed the
rebalancing date. I measured the performance
of the indexes with a standard backtest, assum-
ing that the fundamental factor information was
readily available. Although this setting is typically
unproblematic for the factor land area, it intro-
duces a look-ahead bias for the other factors,
whereby the information is usually unavailable
right after the end of the particular year. To
determine whether look-ahead bias influenced
the results, I performed robustness checks by
moving the rebalancing dates by up to 12 months.
First Quarter 2017
 Fundamental Indexing in Global Bond Markets

Figure 1. Country Weights

Market Value Weighted Composite

South Africa 100 100
Malaysia 80 80

Singapore 60 60

Mexico 40 40

Greece 20 20

Poland 0 0
1991 1996 2001 2006 2011 1991 1996 2001 2006 2011
Finland
Portugal GDP Weighted Populaon Weighted

Norway 100 100

80 80
New Zealand
60 60
Austria
40 40
Ireland
20 20
Sweden
0 0
Spain
1991 1996 2001 2006 2011 1991 1996 2001 2006 2011
Belgium
Land Area Weighted Energy Weighted
Denmark
100 100
Switzerland
80 80
Netherlands
60 60
Australia
40 40
Canada
20 20
Italy
0 0
United Kingdom 1991 1996 2001 2006 2011 1991 1996 2001 2006 2011

France
Equally Weighted
Germany 100
Japan 80
United States 60
40
20
0
1991 1996 2001 2006 2011

Notes: This figure depicts the country weights of the market-value-weighted index (benchmark), all four fundamentally weighted
standalone indexes, the composite index that equally weights the four fundamental factors, and the equally weighted index that
equally weights the issuer countries.

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Financial Analysts Journal | A Publication of CFA Institute

Table 2. Overview of Factor Data

GDP Population Land Area Energy Usage

1994 2004 2014 1994 2004 2014 1994 2004 2014 1994 2004 2014

Australia 1.8% 1.6% 3.0% 2.3% 2.2% 1.9% 19.2% 16.2% 13.8% 2.3% 2.3% 2.5%
Austria 1.0 0.8 0.9 1.0 0.9 0.7 1.9 1.7 1.4 0.6 0.6 0.7
Belgium 1.2 1.0 1.2 1.3 1.1 1.0 1.1 1.0 0.9 1.2 1.2 1.2
Canada 3.3 2.8 3.7 3.7 3.4 2.9 20.0 17.2 14.8 5.4 5.2 4.9
Denmark 0.8 0.7 0.7 0.7 0.6 0.5 1.4 1.2 1.0 0.5 0.4 0.4
Finland 0.5 0.6 0.6 0.5 3.2 2.8 0.7 0.7
France 7.0 5.8 6.2 7.5 6.8 5.7 4.8 4.3 3.7 5.7 5.4 5.1
Germany 10.1 8.1 8.1 10.2 9.1 7.1 3.8 3.4 3.0 8.5 7.1 6.3
Greece 0.6 0.0 1.2 0.0 2.1 0.0 0.6 0.0
Ireland 0.3 0.5 0.5 0.5 0.4 0.4 1.8 1.5 1.3 0.3 0.3 0.3
Italy 6.4 4.8 4.9 7.4 6.3 5.2 3.6 3.1 2.7 3.7 3.6 3.3
Japan 19.5 16.8 13.0 15.7 14.4 11.6 3.9 3.6 3.2 10.9 11.0 9.7
Malaysia 0.6 2.5 2.8 1.5
Mexico 2.5 10.2 6.9 3.6
Netherlands 1.8 1.8 1.9 1.9 1.8 1.5 1.2 1.1 0.9 1.7 1.6 1.6
New 0.2 0.2 0.4 0.5 0.4 0.4 3.5 3.0 2.6 0.3 0.4 0.4
Zealand
Norway 0.7 1.0 0.5 0.4 3.2 2.8 0.5 0.6
Poland 0.7 1.1 4.1 3.2 3.1 2.6 1.8 1.9
Portugal 0.5 0.6 1.1 1.0 1.7 1.6 0.5 0.5
Singapore 0.6 0.5 0.1 0.6
South 0.7 4.1 5.0 2.6
Africa
Spain 3.0 2.6 3.3 5.1 4.5 4.1 4.8 4.1 3.6 2.4 2.6 2.5
Sweden 1.5 1.0 1.2 1.2 1.0 0.8 4.5 3.6 3.2 1.3 1.0 1.0
Switzerland 1.4 1.1 1.4 0.9 0.8 0.7 1.3 1.1 1.0 0.6 0.5 0.5
United 5.9 6.4 5.8 7.4 6.7 5.6 3.2 2.9 2.5 5.3 4.8 3.9
Kingdom
United 34.9 40.9 36.0 32.8 32.0 27.6 20.0 17.7 15.5 49.3 47.8 43.9
States

Note: This table shows the country weightings of the fundamentally weighted standalone indexes at the beginning of the years
1994, 2004, and 2014.

Irrespective of the reporting lag applied, I found
similar results (as shown later in the article).
Although some of the factors, especially definitive
GDP numbers, are available only with an even
longer time lag, the index construction is feasible.
First, by relying on estimates of the factor data
(e.g., GDP estimates), we can approximate the
most current factor information. Second, with a
rolling estimation window of five years (and owing
to the low fluctuation in the factor weightings),
deviations between estimates and actual values do
not significantly affect the index construction.

106 cfapubs.org First Quarter 2017

 Fundamental Indexing in Global Bond Markets

Performance Statistics composite index has an average yearly outper-

In this section, I report performance statistics,
including descriptive statistics, for several settings
in both a subperiod analysis and an attribution
analysis.
Descriptive Statistics. I calculated the
five fundamentally weighted government bond
indexes, the market-value-weighted index,
and the equally weighted index for the period
January 1991–December 2014, which covers
24 years of high- and low-interest-rate envi-
ronments, bull and bear markets, and severe
financial market crises. The results show an
outperformance of all fundamentally weighted
indexes and the equally weighted index com-
pared with the market-value-weighted index.
Figure 2 illustrates the development of the
indexes graphically, and Table 3 lists the descrip-
tive statistics.
Over the period analyzed, the market-value-
weighted benchmark earns an average annualized
return of 5.78%. The GDP-weighted index has an
average yearly outperformance of 0.40 percent-
age points (pps); the population-weighted index,
0.73 pps; the energy-weighted index, 0.54 pps;
and the land area–weighted index, 1.22 pps. The
formance of 0.72 pps, and the equally weighted
index outperforms the market-value-weighted
index by 0.98 pps. Volatility is reduced for the
GDP-weighted index, the energy-weighted index,
and the composite index, whereas the other
valuation-indifferent indexes exhibit a higher
volatility than the market-value-weighted index.
As stated earlier, the land area weighting leads
to a substantial deviation from the market-value-
weighting approach, which is also reflected in a
relatively large tracking error.
Table 3 also gives an overview of the indexes’
average bond risk factors. The market-value-
weighted index has an average modified duration
of 5.63 over the sample period; all fundamentally
weighted indexes and the equally weighted index
have a lower duration value. In addition, the table
shows a rating code, whereby 1 stands for an AAA
rating with an increase of 1 point per notch (i.e., 2
for an AA+ rating, 3 for an AA rating, etc.). I based
the rating analysis on the long-term foreign cur-
rency country ratings by Fitch Ratings. Given that
I included only government bonds, the average
rating of all indexes is relatively high. Table 3 also
shows a convexity measure that illustrates the
sensitivity of the duration to a change in interest

Figure 2. Index Plots 1 Jan 1991 = 100

600

500

400

300

200

100

0
Jan/91 Jan/95 Jan/99 Jan/03 Jan/07 Jan/11

GDP Weighted Populaon Weighted Land Area Weighted

Energy Weighted Composite Weighted Equally Weighted
Market Value Weighted

Notes: This figure shows the development of the market-value-weighted index (benchmark),
all four fundamentally weighted standalone indexes (GDP, population, land area, energy),
the composite index that equally weights the four fundamental factors, and the equally
weighted index that equally weights the issuer countries. The index start date is 1 January
1991, with an index value of 100.

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Table 3. Descriptive Statistics, January 1991–December 2014

Multiple
Benchmark Single Factors Factors
Market Value GDP Population Land Area Energy Composite Equally
Weighted Weighted Weighted Weighted Weighted Weighted Weighted

Index value
(end) 399.66 439.55 475.76 536.01 454.67 475.40 505.35
Return
(annual) 5.78% 6.17% 6.50% 7.00% 6.31% 6.50% 6.75%
Excess
return
(annual) 0.40 pps 0.73 pps 1.22 pps 0.54 pps 0.72 pps 0.98 pps
Volatility
(annual) 6.62% 6.24% 6.63% 7.40% 5.59% 6.30% 8.91%
Sharpe
ratio 0.47 0.56 0.58 0.59 0.65 0.61 0.46
Tracking
error 1.35% 2.02% 4.19% 1.94% 2.05% 4.34%

Average
duration 5.63 5.50 5.41 5.18 5.42 5.38 5.18
Average
rating 1.91 1.71 2.22 2.36 1.71 1.99 2.41
Average
convexity 0.61 0.67 0.75 0.89 0.70 0.75 0.89

Notes: This table reports the descriptive statistics of the indexes. Excess returns and tracking errors are calculated with respect to
the market-value-weighted index.

rates. I approximated convexity by using the
12-month rolling average of the monthly change
in duration over the monthly change in yield. All
fundamentally weighted indexes and the equally
weighted index exhibit higher convexity exposures
than the market-value-weighted index.
Figure 3 depicts the differences in bond risk fac-
tors of the valuation-indifferent indexes and the
market-value-weighted index over the observation
period. Figure 3 shows that the difference in dura-
tion increases over time and that the convexity of
the valuation-indifferent indexes exceeds the con-
vexity of the market-value-weighted index for the
entire period. The difference in duration is rooted
in an underweighting of Japanese bonds in the
valuation-indifferent indexes. Japanese bonds saw
a substantial increase in duration from 2005 to
2014. However, the higher convexity of valuation-
indifferent indexes is due not to a specific country
but, rather, to small contribution differences
among a wide range of countries.
To test the significance of the outperformance of
the valuation-indifferent indexes, I regressed—on
a monthly basis—the fundamentally and equally
weighted index returns minus the risk-free rate on
the market-value-weighted index returns minus
the risk-free rate. I used an ordinary least-squares
(OLS) regression, including a variance–covariance
estimation based on Newey and West (1987).
Table 4 reports the results. The alphas of the
fundamentally weighted fixed-income indexes
are positive and, in most instances, statistically sig-
nificant. I found an annualized alpha of 1.01% for
the composite index and annualized alphas ranging
from 0.62% to 1.45% for the standalone funda-
mentally weighted indexes. The equally weighted
index has a positive annualized alpha of 0.40%
(statistically insignificant).

108 cfapubs.org First Quarter 2017

 Fundamental Indexing in Global Bond Markets

Figure 3. Bond Risk Factors: Differences with the Market-Value-Weighted Index

A. Duraon B. Rang C. Convexity

Difference Difference Difference
0.2 2.0 0.9
0.8
0
1.5 0.7

–0.2 0.6
1.0
0.5
–0.4
0.4
0.5
0.3
–0.6
0.2
0
–0.8 0.1

–0.5 0
–1.0
–0.1
–1.2 –1.0 –0.2
Jan/91 Jan/99 Jan/07 Jan/91 Jan/99 Jan/07 Jan/91 Jan/99 Jan/07

GDP Weighted Populaon Weighted Land Area Weighted

Energy Weighted Composite Weighted Equally Weighted
Market Value Weighted

Note: This figure shows the development of the differences in the bond risk factors of the valuation-indifferent indexes and the
market-value-weighted index (benchmark).

Table 4. Regression Output, January 1991–December 2014 (p-values in parentheses)

Multiple
Single Factors Factors
GDP Population Land Area Energy Composite Equally
Weighted Weighted Weighted Weighted Weighted Weighted

Annualized
alpha 0.62%* 0.86%* 1.45% 1.10%** 1.01%* 0.40%
(0.0112) (0.0444) (0.1013) (0.0002) (0.0117) (0.6851)
Beta 0.92 0.96 0.93 0.81 0.91 1.19
Adjusted R2 95.99% 90.96% 68.37% 92.81% 90.43% 78.38%

Notes: This table reports the regression results of all four fundamentally weighted standalone indexes (GDP, population, land
area, energy), the composite index that equally weights the four fundamental factors, and the equally weighted index that equally
weights the issuer countries. The monthly index returns minus the risk-free rate are regressed on the monthly market-value-
weighted index returns minus the risk-free rate. I used 288 data points for each regression setting.
*Significant at the 5% level.
**Significant at the 1% level.

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Financial Analysts Journal | A Publication of CFA Institute
I thus conclude that the fundamental indexing
approach leads to a statistically and economi-
cally significant higher performance than does a
market-value-weighted index when applied to the
government bond market of developed countries.
However, the analysis of the bond risk factors
indicates certain differences in the indexes’ risk
factor exposures. In my study, I tested whether
the outperformance can be explained by the
deviating risk factor exposures (discussed later in
the article).
Subperiod Analysis. I divided the observa-
tion period into four subperiods, as shown in
Figure 4. Table 5 reports the results of the sub-
period analysis for the market-value-weighted
benchmark and the composite index.7 Looking at
the excess returns, we can confirm the outper-
formance found previously for most, but not all,
subperiods. Except for the first subperiod, the
fundamentally weighted index generally yields a
Sharpe ratio superior to that of the market-value-
weighted index. The single-factor OLS regression
shows a negative alpha in the first subperiod,
although it lacks statistical significance.
To gain further insight into which market envi-
ronments are driving the outperformance of
the fundamentally weighted indexes, I divided
the total sample period into different market
environments. I first divided the entire period
into increasing- and decreasing-interest-rate
environments and increasing- and decreasing-
credit-spread environments, finding that the
fundamentally weighted indexes outperform
Figure 4. Subperiods T-Bill Rate (%)
8
Subperiod 1
0
91 93 95
Note: The first subperiod is 1991–1994, the second subperiod is 1995–2000, the third
subperiod is 2001–2008, and the fourth subperiod is 2009–2014.
110 cfapubs.org
in all these market environments. But after
dividing the dataset into bull and bear markets,
calculated on the basis of the performance of
the MSCI World Index, I found a substantial
difference in performance: The fundamentally
weighted indexes outperform in bull markets,
but they underperform the market-value-
weighted index in bear markets.
On the basis of these results, I cannot confirm
for each subperiod the outperformance of the
fundamentally weighted indexes and the equally
weighted index that I found for the entire period.
Rather, my results suggest that valuation-indifferent
strategies do not outperform a market-value-
weighted index in certain market environments.
Attribution Analysis. I conducted a return
attribution analysis to determine which countries
are driving the outperformance of the valuation-
indifferent indexes. I found that an underweight in
Japanese bonds and an overweight in Australian,
Canadian, Mexican, and Polish bonds are the
main drivers of the outperformance of all the
valuation-indifferent indexes. Figure 5 depicts
the exemplary results for the composite index.
The outperformance is thus not systematically
driven by a difference in allocation between newly
industrialized and developed countries. Note,
however, that the countries with a performance-
driving overweight (Australia, Canada, Mexico, and
Poland) all exhibit credit-rating upgrades, whereas
Japan (with a performance-driving underweight)
undergoes several credit-rating downgrades over
the observation period.
Subperiod 2 Subperiod 3 Subperiod 4
97 99 01 03 05 07 09 11 13
First Quarter 2017
 Fundamental Indexing in Global Bond Markets

Table 5. Subperiod Analysis

1 2 3 4
31 Dec 1990– 31 Dec 1994– 31 Dec 2000– 31 Dec 2008–
31 Dec 1994 31 Dec 2000 31 Dec 2008 31 Dec 2014

Return (annual)
Market value weighted 8.59% 5.46% 7.57% 1.82%
Composite weighted 8.15% 6.15% 8.11% 3.60%
Excess return –0.44 pps 0.69 pps 0.54 pps 1.78 pps

Volatility (annual)
Market value weighted 5.96% 6.25% 7.30% 6.40%
Composite weighted 5.91% 5.58% 6.70% 6.71%

Sharpe ratio
Market value weighted 0.81 0.08 0.70 0.27
Composite weighted 0.74 0.22 0.85 0.52

Annualized alpha –0.32% 0.75% 1.16% 1.86%

Notes: This table reports the index statistics for four subperiods of the market-value-weighted index (benchmark) and the compos-
ite index. Excess returns and annualized alphas are calculated with respect to the market-value-weighted index. The calculations
are based on 48, 72, 96, and 72 data points for subperiods 1, 2, 3, and 4.

Figure 5. Relative Rela…ve Performance Contribu…on (%)

Performance 0.35%

Contributions of Countries 0.25%

in the Composite Index 0.15%

0.05%

–0.05%
United Kingdom (UW)

France (UW)
Greece (UW)

Denmark (UW)

Germany (UW)

Belgium (UW)

Italy (UW)
New Zealand (OW)
Portugal (OW)
Ireland (OW)
Norway (OW)
Japan (UW)
Australia (OW)
Mexico (OW)
Canada (OW)

Finland (OW)

Netherlands (UW)
Singapore (OW)
Malaysia (OW)

Switzerland (OW)

South Africa (OW)

Austria (UW)

Spain (OW)

United States (OW)

Poland (OW)

Sweden (OW)

Notes: This figure depicts the relative performance contributions of the countries in the
composite index compared with the market-value-weighted index. Relative performance is
shown as an annualized value for the full period analyzed (January 1991–December 2014).
“UW” indicates an average underweight of the country with respect to the market value
weight; “OW” indicates an average overweight.

Volume 73 Number 1 cfapubs.org 111

Financial Analysts Journal | A Publication of CFA Institute
Risk Factor Analysis
I tested whether the outperformance of the fun-
damentally indexed strategies, though valid, might
be due to a difference in the risk exposures. Some
have criticized the outperformance of fundamen-
tally weighted equity indexes as having its roots in
a value tilt; the outperformance of the fundamen-
tally weighted fixed-income indexes might suffer a
similar tilt in fixed-income risk exposures.
I tested whether the abnormal returns remain
positive and significant when accounting for the
risk factor exposures of the various indexes. As a
starting point, I used the Fama and French (1992)
equity risk factors for size (small minus big, or
SMB) and valuation (high minus low, or HML),
which can be considered potential risk factors for
both equities and bonds. I obtained the Fama and
French equity risk factors from the global dataset
provided by Kenneth R. French.8 On the basis of
Fama and French (1993) and analogous to Arnott
et al. (2010), I also extended the model with the
following two bond-specific risk factors: term risk
(TERM), which accounts for the difference in long-
term and short-term government bond returns,
and default risk (DEFAULT), which captures the
corporate bond spreads. I calculated the factor
TERM by subtracting long-term government bond
returns (maturities of over 10 years) from short-
term government bond returns (maturities under
3 years) on a monthly basis. The factor DEFAULT
reflects the difference between monthly govern-
ment bond returns and corporate bond returns.
Although the fundamental indexes contain gov-
ernment bonds only, default risk might be a major
driver of returns given the global scope and the
inclusion of lower-rated countries. I obtained the
necessary data from Datastream.
In addition, I included the following risk factors,
which were not considered in prior research:
•• Duration risk
•• Convexity risk
•• Liquidity risk
•• Carry trade risk
First, I complemented the bond risk factor TERM
with an additional risk factor for duration. TERM
112 cfapubs.org
reflects the fact that long-term bonds gener-
ally feature higher interest rates than short-term
bonds because duration risk increases with longer
bond terms. I took an additional perspective on
duration risk by considering that countries with
high-duration bonds might have a different yield
level than countries with low-duration bonds. In
fact, my analysis shows that countries with a high
average duration have a lower yield level than
countries with a low average duration. I believe
that the explanation for this connection can be
found by inverting the relationship: Countries in
a low-interest-rate environment generally issue
longer-term bonds, whereas countries in a high-
interest-rate environment issue shorter-term bonds.
For example, the maturities of Japanese bonds
have increased substantially over the past 10
years, reflecting Japan’s low-interest-rate environ-
ment. Comparing index methodologies, we would
thus expect those indexes that show a higher
exposure to countries issuing high-duration bonds
to underperform. Table 3 shows that the market-
value-weighted index exhibits the highest average
duration. Therefore, the outperformance of the
fundamentally weighted indexes might further be
explained by their increased allocation to low-
duration countries, which exhibit higher yields.
To test this theory, I separated the countries into
two portfolios, with the first portfolio containing
the bonds of countries with a low average duration
(measured as modified duration) and the second
portfolio containing countries with a high average
duration. To measure duration, I used the same
country indexes that I used to create the market-
value-weighted and valuation-indifferent indexes.
Thus, data availability and country selection match.
For example, at the start of the analysis, I used 11
countries to construct the market-value-weighted
and valuation-indifferent indexes. I then used the
same 11 countries to construct the low-duration
and high-duration portfolios. With the increasing
number of countries included in the indexes, the
number of countries considered for the duration
portfolios increased (see Table 1 for the launch date
information for the country indexes). I rebalanced
the portfolios every month. For calculating the
returns on the two portfolios, I equally weighted
the returns of the countries in each portfolio. I did
First Quarter 2017
 Fundamental Indexing in Global Bond Markets
not consider market value weights or market size
indicators when constructing the portfolios or
when calculating the portfolio returns. Finally, I built
the duration risk factor (DURATION) by subtracting
the returns of the second portfolio (countries with
high duration) from the returns of the first portfolio
(countries with low duration).
Second, I extended the bond risk factors by
including convexity risk (CONVEXITY). Bonds
with high convexity risk generally have higher
returns, owing to the lower interest rate sensitiv-
ity in an increasing-interest-rate environment and
higher interest rate sensitivity in a decreasing-
interest-rate environment. Therefore, I divided
the country index universe into two portfolios,
with the first portfolio containing countries with
bonds featuring high convexity risk and the
second portfolio containing countries with bonds
featuring low convexity risk. I approximated con-
vexity by using the 12-month rolling average of
the monthly change in duration over the monthly
change in yield. As with the duration risk fac-
tor, I created the portfolios with those countries
that were part of the market-value-weighted and
valuation-indifferent indexes at a specific point
in time (see Table 1 for the launch date informa-
tion for the country indexes). I rebalanced the
portfolios monthly and calculated their returns by
equally weighting the returns of the constituent
countries. Again, I did not consider market value
weights or market size indicators when construct-
ing the portfolios or when calculating the port-
folio returns. I then calculated the regression risk
factor CONVEXITY by subtracting the returns of
the low-convexity portfolio from the returns of
the high-convexity portfolio.
Third, I extended my risk factor analysis by testing
the abnormal returns for liquidity risk (LIQ). Given
the high interdependence of liquidity and volatil-
ity, I approximated liquidity risk by using changes
in the Chicago Board Options Exchange (CBOE)
Volatility Index (VIX). For a detailed discussion of
this relationship, see Brunnermeier and Pedersen
(2009), Adrian and Shin (2010), and Nagel (2012). I
obtained the VIX data from the CBOE.
Finally, I included a carry trade risk factor
(CARRY). I considered the currencies of the
Volume 73 Number 1 cfapubs.org
analyzed countries with respect to the US dollar.
Because of better data availability, I included in
the carry trade risk factor all 26 countries that
were part of the market-value-weighted and
valuation-indifferent indexes from the start. I
then calculated the carry trade return risk factor
by separating the currencies into two portfolios,
with the first portfolio containing the currencies
with high interest rate differentials vis-à-vis the
US dollar and the second portfolio containing
the currencies with low interest rate differentials
vis-à-vis the US dollar. I rebalanced the portfo-
lios every month. Following Hu, Pan, and Wang
(2013), I calculated the return for each currency
pair as
rt + 1 = it* − it + st − st + 1
= it* − it − ∆st + 1 ,
where it* is the foreign risk-free rate, it is the US
risk-free rate, and st is the log of the spot foreign
exchange rate of the foreign currency to the US
dollar at time t. I calculated the portfolio returns
by equally weighting the returns of the curren-
cies in each portfolio. Again, I did not consider
market value weights or market size indicators
when constructing the portfolios or when
calculating the portfolio returns. Finally, I built
the carry trade return risk factor (CARRY) by
subtracting the returns of the second portfolio
(currencies with low interest rate differentials)
from the returns of the first portfolio (currencies
with high interest rate differentials). Table 6
reports the descriptive statistics of these
regression risk factors.
The following equation shows the multifactor
regression approach:
( )
rfw = α + rf + β1 rmv − rf + β2 SMB + β3HML
+ β4 TERM + β5DURATION + β6DEFAULT
T
+ β7 CONVEXITY + β8LIQ + β9CARRY + ε ,
where rfw is the return of the valuation-indifferent
indexes and rmv is the return of the market-value-
weighted index.9 Because I considered the returns
of the market-value-weighted index market returns,
the resulting regression alpha can be interpreted
113
Financial Analysts Journal | A Publication of CFA Institute

Table 6. Descriptive Statistics of Risk Factors, January 1991–December 2014

Market
Return SMB HML TERM DURATION DEFAULT CONVEXITY LIQ CARRY

Mean 0.25% 0.03% 0.34% 0.33% 0.10% 0.03% 0.06% –0.11% 0.22%
Median 0.19% –0.05% 0.24% 0.42% 0.24% 0.06% 0.08% –1.28% 0.40%
Std. dev. 1.92% 2.07% 2.31% 1.63% 1.02% 1.54% 1.01% 17.44% 1.57%
Skewness 0.08 –0.21 0.23 –0.11 –0.25 –0.90 –0.57 0.48 –0.88
Kurtosis 0.58 3.39 5.15 0.77 2.25 8.09 2.15 0.56 2.72
Significance
(p-value) 0.0139 0.3935 0.0065 0.0003 0.0423 0.3515 0.1453 0.5427 0.0102

Notes: This table reports the descriptive statistics of the regression risk factors: (1) the monthly market-value-weighted govern-
ment bond index return minus the risk-free rate (market return), (2) the Fama–French equity risk factor SMB (size), (3) the Fama–
French equity risk factor HML (book to market), (4) the bond risk factor TERM, (5) the country risk factor DURATION, (6) the bond
risk factor DEFAULT, (7) the bond risk factor CONVEXITY, (8) liquidity risk (LIQ; approximated by the VIX index), and (9) carry
trade risk (CARRY). The calculations are based on monthly data points.

directly as an abnormal return (i.e., as an out- or
underperformance of the valuation-indifferent
indexes with respect to the market-value-weighted
benchmark). Thus, the exposure to the remaining
explanatory variables should also be interpreted
as risk factor exposure that is additional to the
risk factor exposure in the market-value-weighted
index. The risk factors for duration, convexity,
liquidity, and carry trade represent the newly intro-
duced risk factors that have not been considered in
prior research and that can provide further insights
into the sources of outperformance of fundamen-
tally weighted fixed-income indexes.
Table 7 reports the risk factor regression results for
the fundamentally weighted composite index. The
equity risk factors SMB and HML show no signifi-
cant exposures. As expected, the standard bond
risk factors TERM and DEFAULT exhibit statistically
significant and economically relevant beta values.
Regression setting 1, which includes the bond risk
factors considered in previous studies (TERM and
DEFAULT), yields a statistically significant annual-
ized alpha—and thus an outperformance of the
composite index with respect to the market-value-
weighted bond index—of 90 bps.10
The fundamentally weighted composite index also
shows a highly significant exposure to the newly
introduced bond risk factors DURATION (regression
setting 2) and CONVEXITY (regression setting 3).
With these new bond risk factors included, the annu-
alized alpha is reduced to 44 bps. Thus, the higher
exposure to these new risk factors explains another
aspect of the outperformance of the fundamentally
weighted composite index.
I extended my regression analysis by including the
liquidity and carry trade risk factors (regression set-
tings 4 and 5). The index returns show a somewhat
statistically significant exposure to liquidity risk (LIQ),
although the economic impact of the risk factor is
rather low. However, the fundamentally weighted
strategy shows a substantial exposure to the carry
trade risk factor (CARRY). Not only is CARRY highly
statistically significant, but it can also explain the
remainder of the abnormal returns. With the addi-
tional risk factors included, the annualized alpha
shrinks to 24 bps and loses its statistical significance.
This extension of the risk factor universe leads to
the conclusion that the abnormal returns found
earlier can be attributed to higher term, duration,
default, convexity, and carry trade risk exposures
of the fundamentally weighted composite index.
The explanatory power of the models, measured
by the adjusted R2, is shown in the last row of
Table 7. The explanatory power increases continu-
ously with the inclusion of the new risk factors.
Obviously, the largest amount of the models’

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 Fundamental Indexing in Global Bond Markets

Table 7. Risk Factor Regression: Composite Index, January 1991–December 2014

(p-values in parentheses)

Composite Index
(unhedged returns)
Regression Setting 1 2 3 4 5

Annualized alpha 0.90%** 0.50%* 0.44% 0.42% 0.24%

(0.0023) (0.0405) (0.0606) (0.0702) (0.3112)
Market return 69.0%** 71.5%** 72.8%** 74.5%** 78.8%**
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
SMB –0.3% –0.7% –0.6% –0.1% –0.7%
(0.8340) (0.5668) (0.6012) (0.9173) (0.5877)
HML 1.2% 0.7% 1.0% 1.4% 1.2%
(0.2788) (0.4989) (0.2923) (0.1470) (0.1419)
TERM 14.6%** 16.4%** 15.8%** 15.1%** 11.9%**
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
DURATION 23.4%** 19.0%** 17.9%** 14.2%**
(0.0000) (0.0000) (0.0000) (0.0000)
DEFAULT 29.8%** 24.3%** 21.7%** 18.7%** 15.0%**
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
CONVEXITY 13.2%** 12.7%** 7.7%*
(0.004) (0.0002) (0.0267)
LIQ –0.5%** –0.2%
(0.0001) (0.1248)
CARRY 11.7%**
(0.0011)

Adjusted R2 93.42% 94.94% 95.37% 95.53% 96.09%

Notes: This table reports the risk factor regression results of the composite index (unhedged returns). The monthly index returns
minus the risk-free rate are regressed on several risk factors (see the notes to Table 6). I used 288 data points for each regression
setting.
*Significant at the 5% level.
**Significant at the 1% level.

explanatory power stems from the market return.
However, we can quantify the value added by
the other explanatory variables by comparing
the adjusted R2 of the risk factor regression with
the adjusted R2 of the single-factor regression in
Table 4, where the market return represents the
only explanatory variable. For the fundamentally
weighted composite index, the inclusion of the
risk factors increases the explanatory power from
90.43% to 96.09%. Thus, the investigated risk
factors substantially improve our understanding of
the sources of outperformance in the fundamental
indexing methodology.
Table 8 reports the risk factor regression results
for the fundamentally weighted standalone
indexes and the equally weighted index (regres-
sion setting 5).11 Table 8 confirms the results

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Table 8. Risk Factor Regression: Standalone Indexes and Equally Weighted Index, January
1991–December 2014 (p-values in parentheses)

Regression Setting 5
(unhedged returns)
Index GDP Population Land Area Energy Equally Weighted

Annualized alpha 0.29% 0.20% 0.05% 0.31% –0.38%

(0.1798) (0.4691) (0.9240) (0.1115) (0.5220)
Market return 85.9%** 86.5%** 71.5%** 70.6%** 104.0%**
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
SMB –1.6% –2.0% 2.8% –1.2% –0.9%
(0.1313) (0.1617) (0.1888) (0.2999) (0.7490)
HML 0.3% 1.6% 2.4% 0.7% 5.0%*
(0.6981) (0.0689) (0.1586) (0.3873) (0.0159)
TERM 6.6%** 6.7%** 16.5%** 18.7%** –3.8%
(0.0009) (0.0027) (0.0012) (0.0000) (0.3589)
DURATION 5.5% 14.8%** 32.3%** 7.3%** 41.0%**
(0.0840) (0.0007) (0.0000) (0.0087) (0.0000)
DEFAULT 8.2%** 13.6%** 31.7%** 6.8%* 35.6%**
(0.0085) (0.0002) (0.0000) (0.0184) (0.0000)
CONVEXITY 2.8% 13.2%** 6.8% 7.2%** 10.9%
(0.3783) (0.0002) (0.4080) (0.0037) (0.2175)
LIQ 0.1% –0.1% –1.0%** 0.0% 0.0%
(0.3542) (0.7154) (0.0026) (0.8247) (0.8996)
CARRY 5.1% 10.3%** 25.8%** 6.3%** 17.3%*
(0.0995) (0.0036) (0.0001) (0.0094) (0.0486)

Adjusted R2 96.94% 95.97% 87.70% 96.55% 91.11%

Notes: This table reports the full regression (regression setting 5) for the fundamentally weighted standalone indexes and the
equally weighted index (unhedged returns). See the notes to Table 6 for a detailed description of the variables.
*Significant at the 5% level.
**Significant at the 1% level.

found earlier for all the standalone weighting
methodologies; that is, the abnormal positive
returns found earlier can be fully explained by
the analyzed risk factors. None of the standalone
indexes show a statistically significant abnormal
return after accounting for the differences in risk
exposures. The land area–weighted index, which
exhibits the largest deviation in country allocation
of the fundamentally weighted indexes, has the
highest exposures to the risk factors DURATION
and DEFAULT. The GDP-weighted index and the
energy-weighted index, which show the highest
average allocation to the United States, have the
lowest exposure to the risk factor DEFAULT. Like
the fundamentally weighted indexes, the equally
weighted index does not exhibit abnormal returns
that are unexplainable by risk factor exposure.
For all the indexes, the risk factors for duration,

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 Fundamental Indexing in Global Bond Markets

convexity, and carry trade seem to be responsible
for a substantial amount of the outperformance. The
inclusion of the risk factors increases the explanatory
power of the model for the GDP-weighted index
by 0.95 pps, for the population-weighted index by
5.01 pps, for the land area–weighted index by
19.34 pps, for the energy-weighted index by 3.74
pps, and for the equally weighted index by 12.74
pps. For the indexes that show large deviations
from the market value weighting (e.g., the land
area–weighted index and the equally weighted
index), the examined risk factor universe
explains a substantial (and additional) part of the
performance.
Table 9 reports the results of the robustness
check for the hedged versions of the fundamen-
tally weighted indexes. In this analysis, I used local
currency returns and took the interest rate differ-
entials into account as hedging costs. By looking at
hedged returns, I excluded any foreign exchange
effects, which is reflected in the results showing
that the significant exposure to carry trade risk is
substantially reduced, vanishing entirely for some

Table 9. Robustness Check for Hedged Returns, January 1991–December 2014

(p-values in parentheses)

Regression Setting 5
(hedged returns)
Index GDP Population Land Area Energy Composite Equally Weighted

Annualized alpha –0.16% –0.39%** –0.54%* –0.30% –0.34%* –0.78%**

(0.1874) (0.0016) (0.0156) (0.1052) (0.0109) (0.0023)
Market return 100.8%** 102.2%** 99.3%** 95.8%** 99.5%** 110.7%**
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
SMB 0.6% 0.3% 0.6% 0.3% 0.5% 0.3%
(0.1054) (0.3883) (0.4111) (0.6420) (0.2908) (0.7190)
HML –0.1% 0.0% –0.5% –0.4% –0.2% 0.6%
(0.7527) (0.9710) (0.4542) (0.3763) (0.4950) (0.5092)
TERM 4.9%** 3.8%* 8.1%** 10.5%** 6.8%** –2.5%
(0.0087) (0.0123) (0.0012) (0.0000) (0.0000) (0.3424)
DURATION 5.3%** 13.1%** 23.1%** 6.1%* 11.6%** 32.7%**
(0.0013) (0.0000) (0.0000) (0.0169) (0.0000) (0.0000)
DEFAULT 0.6% 1.1% –0.2% 2.4%** 1.0% –2.4%
(0.2612) (0.0872) (0.8610) (0.0056) (0.1279) (0.1034)
CONVEXITY 2.3% 10.8%** 7.6% 4.2% 6.1%* 9.5%
(0.2926) (0.0000) (0.2898) (0.1983) (0.0340) (0.1312)
LIQ 0.2%** 0.0% –0.2% 0.1% 0.0% 0.0%
(0.0059) (0.8639) (0.2672) (0.1222) (0.5759) (0.9439)
CARRY –0.8% 0.9% 0.0% –1.7%* –0.4% 3.7%**
(0.1829) (0.2163) (0.9866) (0.0382) (0.5109) (0.0065)
Adjusted R2 97.85% 97.10% 89.56% 95.75% 97.05% 86.59%

Notes: This table reports the full regression (regression setting 5) for all fundamentally weighted indexes and the equally weighted
index (hedged returns). See the notes to Table 6 for a detailed description of the variables.
*Significant at the 5% level.
**Significant at the 1% level.

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indexes. As opposed to the unhedged environ-
ment, the abnormal returns in the hedged environ-
ment are consistently negative when accounting
for the full set of risk factors; however, I did not
find statistical significance for all indexes. The
robustness check shows that in terms of hedged
returns, the valuation-indifferent indexes cannot
outperform systematically when accounting for
differences in the risk factor exposures.
Finally, I also conducted a robustness check to
test whether my assumption of readily available
fundamental factor information influenced the
results for the fundamentally weighted indexes
(look-ahead bias). I performed the robustness
check by moving the rebalancing dates by up to
12 months. Table 10 reports the results for all the
fundamentally weighted indexes. By comparing
Table 10 with Tables 7 and 8, we can clearly see
that the Table 10 results are not influenced by
look-ahead bias and that my conclusions remain
unaltered after introducing a reporting lag.

Table 10. Robustness Check: Reporting Lag, January 1991–December 2014

(p-values in parentheses)

Regression Setting 5 (unhedged returns)/Reporting Lag: 12 Months

Index GDP Population Land Area Energy Composite

Annualized alpha 0.34% 0.20% 0.05% 0.31% 0.25%

(0.1104) (0.4693) (0.9232) (0.1118) (0.2822)
Market return 86.2%** 86.7%** 71.5%** 70.6%** 79.0%**
(0.0000) (0.0000) (0.0000) (0.0000) (0.0000)
SMB –1.5% –2.0% 2.8% –1.2% –0.6%
(0.1276) (0.1623) (0.1890) (0.2953) (0.5992)
HML 0.3% 1.6% 2.4% 0.6% 1.2%
(0.7051) (0.0692) (0.1590) (0.4036) (0.1431)
TERM 6.4%** 6.5%** 16.5%** 18.7%** 11.8%**
(0.0012) (0.0031) (0.0012) (0.0000) (0.0000)
DURATION 5.9% 14.8%** 32.3%** 7.3%** 14.3%**
(0.0512) (0.0006) (0.0000) (0.0075) (0.0000)
DEFAULT 7.1%* 13.6%** 31.7%** 6.7%* 14.6%**
(0.0267) (0.0002) (0.0000) (0.0188) (0.0000)
CONVEXITY 3.0% 13.1%** 6.8% 7.1%** 7.8%*
(0.3295) (0.0002) (0.4082) (0.0039) (0.0257)
LIQ 0.1% –0.1% –1.0%** 0.0% –0.2%
(0.4476) (0.7284) (0.0026) (0.8600) (0.1152)
CARRY 4.5% 10.3%** 25.8%** 6.2%* 11.5%**
(0.1188) (0.0037) (0.0001) (0.0102) (0.0011)

Adjusted R2 97.08% 96.0% 87.70% 96.59% 96.13%

Notes: This table reports the full regression (regression setting 5) for all fundamentally weighted indexes when applying a reporting
lag of 12 months. See the notes to Table 6 for a detailed description of the variables.
*Significant at the 5% level.
**Significant at the 1% level.

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 Fundamental Indexing in Global Bond Markets
To summarize, I found statistically significant and
economically relevant evidence that the funda-
mentally weighted government bond indexes
exhibit an elevated risk exposure and thus earn a
higher compensation for such elevated risk expo-
sure. My finding analogous results for the equally
weighted index further supports this argument.
For investors, valuation-indifferent indexing strat-
egies should still be seen as a valid alternative for
overcoming the known issues concerning market-
value-weighted indexes, such as the systematic
shift toward countries with an increasing volume
of outstanding debt or a potentially unwanted
high-market-value weighting of a few countries.
When following fundamental indexing strategies,
however, investors need to be aware that histori-
cal outperformance can be explained by differ-
ences in risk factor exposures.
Conclusion
I confirmed the outperformance of several funda-
mental indexing approaches by applying that meth-
odology to government bond markets globally. My
findings, however, suggest that the outperformance
of the fundamentally weighted strategies, though
valid, can be explained by differences in risk factor
exposures. First, I found evidence that the method-
ology does not deliver consistently superior results
in all subperiods but, rather, depends on a specific
time frame and market environment. Second, my
regression analyses reveal statistically significant
and economically relevant loadings on several risk
Notes
1. Arnott et al. (2005) coined the term “fundamental index-
ing” for their alternative indexing approach in equity mar-
kets because of their reliance on fundamental company
factors. When applying this approach to fixed-income
markets, especially government bonds, they sometimes
referred to it by the broader term “valuation-indifferent
weighting” because they used country characteristics
instead of company fundamentals as the weighting mecha-
nism. Other alternative weighting approaches, however,
such as an equal-weighting strategy, could be classified
as a valuation-indifferent weighting scheme but would
not be classified as a fundamental indexing approach.
Therefore, for the sake of comprehensibility and readabil-
ity, in this article I also use the term fundamental indexing
with respect to fixed-income markets and apply the term
valuation-indifferent weighting in its broader meaning.
Volume 73 Number 1 cfapubs.org
factors. I tested the previously investigated bond
risk factors term and default and extended the risk
factor universe to include the newly introduced
explanatory risk variables duration, convexity,
liquidity, and carry trade. Exposures to the risk fac-
tors that were not considered in prior research can
explain a substantial part of the abnormal returns of
valuation-indifferent indexes.
My intention is not to dissuade investors from
using fundamentally weighted indexes; in fact,
quite the opposite is true. I believe that it is cru-
cial to provide investors with alternatives to the
predominant market-value-weighting approach in
indexing, and fundamental indexing remains an
appealing alternative for overcoming some of the
issues inherent in market-value-weighted indexes.
My study and its direct implications are limited to
government bond markets of developed countries.
Future research—especially regarding other fixed-
income asset classes—is needed to broaden my
findings. Given the growth in alternative indexing
strategies, I see a significant practical relevance in
conducting research in this field. I believe that the
growth in passive investing will continue unabated,
making future studies on the causes of perfor-
mance differences between indexing methodolo-
gies essential.
Editor’s Notes
Submitted 7 August 2015
Accepted 7 July 2016 by Stephen J. Brown
2. I started the observation period in January 1991 owing to
the availability of the global equity risk factor dataset pro-
vided by Kenneth R. French (http://mba.tuck.dartmouth.
edu/pages/faculty/ken.french/index.html).
3. For example, the bonds were required to have a mini-
mum remaining life of one year and a specified minimum
issue size depending on the country. See the Citigroup
index construction methodology for a detailed descrip-
tion of the index criteria, not shown here for the sake of
brevity (https://www.yieldbook.com/m/indices/single.
shtml?ticker=WGBI).
4. See http://data.worldbank.org.
5. Owing to gaps in the dataset, the data for energy usage had
to be approximated for 2013 and to some extent for 2012.
119
Financial Analysts Journal | A Publication of CFA Institute
6. The robustness checks regarding the rolling-window size
show that my conclusions are unaltered under a changed
assumption. For the sake of brevity, those results are
unreported.
7. For the sake of brevity, I do not report the results for all
valuation-indifferent indexes, but those results are avail-
able upon request.
8. See http://mba.tuck.dartmouth.edu/pages/faculty/ken.
french/index.html.
9. I tested the multifactor regression approach for potential
multicollinearity between the explanatory variables by
calculating the pairwise correlations and the variance
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