What is meant by the bum's problem associatedwith a market-cap-weighted bond market index?

Question

What will be an ideal response?

Answer 1

The bum's problem is the problem associated with the notion that benchmarks (like a market-cap-weighted bond market index) are dominated by large issuers. More details are given below.

Customized bond indexes have been developed to provide either more tailor-made benchmarks that reflect the investment objectives and risk tolerance of investors or to remove the concentration risk of large issuers dominating the index (i.e., the bum's problem). An example of a customized bond index to better reflect the investment objectives and risk tolerance would be an institutional investor designing a bond index that only includes the proprietary investment rules that it has established for its investment management team. For example, suppose that a life insurance company has established rules for the types of bonds and maximum amount in which its bond portfolio management team may invest, and further suppose those rules differ from the rules for existing bond market indexes. The life insurer would benefit from a customized bond index because any existing bond market index is not representative of the investment universe available to its investment management team.

An equally weighting scheme addresses the bum's problem by not allowing large issuers dominate as they are only allowed contributions equal to those of others. The empirical question is how equally weighted bond indexes perform relative to market-cap-weighted bond indexes in terms of risk and return. Using the Sharpe ratio as a measure of return relative to risk, one study finds that the Dow Jones Equal Weight U.S. Issued Corporate Bond Index outperformed market-cap-weighted corporate bond indexes.

A company's fundamentals are its characteristics such as cash flow, book-to-value ratio, dividend per share, sales growth, and the like. In the equity market, indexes have been created where the weight assigned to a company in the index is based on a set of company fundamentals. The resulting index is called a fundamental index. The idea of fundamental indexing was first applied to bond indexes by Research Affiliates, leading to the launch, in a joint effort with Ryan ALM, of two RAFI U.S. corporate bond indexes (one for investment-grade corporates and the other for high-yield corporates). As with equal weighting, a fundamental bond index addresses the bum's problem. Another corporate bond index proposed by Research Affiliates that is a blend of equally weighting and a market-cap weighting scheme is based on the face value of debt rather than on market value. The weighting scheme only partially addresses the bum's problem.

In January 2009 a weighting scheme for international government bond indexes was proposed by PIMCO and later in that same year by Barclays Capital based on GDP. Basically the approach addresses the bum's problem whereby larger weights are assigned to countries that borrow heavily and are likely to be those governments that might default. To correct for this, PIMCO proposed using as the weighting a country's debt by its GDP.

A risk-weighted Treasury index that has a laddered maturity of Treasury issues was created jointly by Ryan ALM and Mergent, the Ryan/Mergent U.S. Treasury Ladder Index Family. The 30 Treasury issues in the index are equally weighted fixed-coupon U.S. Treasury issues, with one issue maturing each year for 30 years. By construction, this family of Treasury indexes eliminates the bum's problem because the market value of the 30 Treasury issues exerts no influence on the index.

A family of Treasury indexes comprised of only U.S. Treasury strips has been developed by Ryan ALM—the Ryan Strips30 Index Family. The indexes include 30 Treasury strips, with each Treasury strip being the most representative for its maturity. Each index is designed to have a constant duration and there is no bum's problem.