Investors who own global or international bond index funds may be taking on more risk than they realize. While these funds have the typical risks associated with bond funds and international investing – currency risk, interest-rate risk, etc. – there may be another, hidden danger: the way the indices themselves are constructed.

Most international and global bond indices take the typical approach to index construction: creating a portfolio that represents the composition of the underlying index.


With stock funds, this means that index funds hold their largest positions in the market’s biggest companies: the Apples and Exxons of the world. In the realm of global bond funds, however, this same approach means that the funds are “capitalization weighted,” which means they base their weightings on the size of each country’s bond market.

The problem with this approach is that it gives the highest weighting to the countries with the largest amount of debt - which in many cases also happen to be the countries with the most troubled finances. The result is that funds linked to global indices may hold their largest exposure to the unhealthiest issuers. Or, as the asset manager PIMCO puts it: “Because larger stocks of debt mean higher market capitalization, market capitalization-weighted indexes are at a structural disadvantage as they have a bias to assign greater weights to highly indebted countries, even though the credit quality of those issuers may be eventually compromised by their debt load.”

A prime example of this problem is the large weighting many index funds hold in Japan, which makes up over 20% of most international indices. The reason Japan’s bond market is so large is that the country is saddled with debt. Its debt- to-GDP ratio is the highest in the world and expected to remain so for years, and some pundits have declared that Japan will be the next victim of the type of debt crisis that has plagued Europe in recent years. Owning a fund with more than a fifth of its portfolio in Japan – where most government bonds yield 1% or less – isn’t necessarily the best approach, but it’s a position that index investors own nonetheless. Further, it’s one that indicates that investors in international index funds aren’t getting as much diversification as they think.

This isn’t an issue that’s confined solely to index funds. Even actively managed funds can be affected by this, since their managers are judged by their performance relative to the benchmark. As a result, moving too far away from the benchmark weightings means that the manager is risking underperformance – and his or her job. Since most benchmarks are capitalization-weighted, this dynamic means that even active managers may be inclined to hold larger weightings in countries such as Japan than they typically would.

The Solution

The answer to this problem is an approach that focuses not on market capitalization, but on gross domestic product of the issuing countries – or in other words, the size of a country's economy rather than its debt load. According to an October, 2012 article in the Wall Street Journal titled "Is Your Bond Strategy Wrong?", this approach has worked well. The Journal article states: “Since 2009, the earliest data available, GDP-weighted portfolios have outperformed market-cap-weighted bond portfolios by about 1.3 percentage points a year.” It's a small data set, but one that indicates that a change may on the way for the world of bond index funds.

So far, this change is happening slowly. Fidelity’s Global Bond Fund (ticker:FGBFX) and International Bond Fund (FINUX) are benchmarked against GDP-weighted benchmarks rather than cap-weighted benchmarks. The bond giant PIMCO has patented a GDP-weighed benchmark and operates the PIMCO Global Advantage Strategy Fund  (PGSAX), which has performed well since its inception but requires investors to pay a 3.75% front-end sales commission.

At this point, U.S. investors have only limited options in this area, and there as yet no international bond ETFs based on GDP-weighted indices such as the Barclays World GDP Index. But stay tuned: this approach is gaining more traction with institutions, so it’s an area sure to experience growth in the years ahead.