When Rob Arnott, the creator of fundamental indexing, spoke in Toronto last week, his presentation focused exclusively on equities. When he took questions at the end of his presentation, I asked him a question about the lesser-known RAFI fundamental bond indexes.

Recall that the goal of fundamental indexing is to address the flaws in capitalization-weighted indexes, which give the most influence to stocks that may be overpriced. Traditional bond indexes are cap-weighted, too: the more bonds a country or corporation issues, the greater their weight in the index. Arnott and others have criticized this methodology, so I asked him to comment. Here’s what he said:

“If you’re bond investor, you’re a lender. If you’re cap-weighted, then you’re lending the most to whomever has the most debt. What is the rationale behind that? If you’re investing in a global sovereign bond fund and Greece decides it wants to double its debt, as an index investor you would have to own twice as much. What’s the sense of that?

“Cap-weighting in bonds is patently ridiculous. Cap-weighting in stocks has a lot of theoretical justification, but when you use the same theories and apply them to bonds, it just becomes more obvious that the rationale is stupid.”

Ridiculous, stupid — these are strong words. But before you rush to dump your bond index fund, let’s take a closer look at Arnott’s argument.

A red herring

On the surface, the criticism of cap-weighted bond indexes seems to make sense. If you’re a mortgage lender, do you want you lend more money to people who already have the largest home loans? If you’re credit card company, do you look for customers who owe the most on their existing cards? Of course not. You look for borrowers with good “fundamentals”: a reliable job, a low debt-to-income ratio, a good credit history and the like.

But this has no relevance to the vast majority of index funds and ETFs that hold government bonds.

For starters, most investors hold all of their bonds in their own country—as they should. Unlike with equities, there are sound reasons for keeping your fixed income in your home country and currency. Some investment gurus, such as David Swensen and Larry Swedroe, even argue that you should avoid corporate bonds and stick to bonds issued by your own government. In other words, global sovereign bond funds are not a major part of most index investors’ fixed income holdings.

Even if you did decide to add foreign bonds in your index portfolio, the reference to Greece (or any other country at high risk of default) is a red herring. Cap-weighted bond index funds screen for credit risk, so no investor is in danger of being unwittingly saddled with a bunch of fiscal basket cases.

For example, the CIBC Global Bond Index Fund, the only one of its kind in Canada, tracks the cap-weighted J.P. Morgan Global Government Bond Index, which includes only investment-grade bonds. Most of the fund is in Japan, the United States, France, the UK, Germany, the Netherlands and Germany. (There are small allocations to Italy and Spain, which may concern you, but this is a criticism of bond-rating agencies, not cap-weighted indexes.)

The SPDR Barclays Capital International Treasury Bond ETF (BWX), listed in the US, is a perfect example of the methodology in action. This ETF used to have an allocation to Greece (according to this February 2010 article), but it doesn’t anymore, because the country’s credit rating has since been lowered and it’s no longer eligible for the index.

Other safeguards

Other sovereign bond ETFs use different methods to make sure deeply indebted countries are not overrepresented. The US-listed iShares S&P/Citigroup International Treasury Bond Fund (IGOV) starts with a cap-weighted index but makes adjustments “designed to distribute the weights of each country within the index by limiting the weights of countries with higher debt outstanding and reallocating this excess to countries with lower debt outstanding.”

If you’re an investor who wants high-risk bonds issued by emerging countries, you’re still not likely to run into any problems with index ETFs. BMO’s Emerging Markets Bond ETF tracks an index “weighted by gross domestic product as a measure of economy size.” The recently launched iShares J.P. Morgan USD Emerging Markets Bond Index Fund (XEB) uses the same safeguard as IGOV.

Designing a bond index fund that systematically overweights countries in danger of defaulting would indeed be “ridiculous” and “stupid.” Which explains why no bond index fund seems to be doing it.