Ron Ryan says there’s a problem with bond indexes that are tracked by exchange traded funds (ETFs). In fact, the CEO of Ryan ALM says that there are several problems and he’s out to fix them.

The first issue with traditional bond indexes, he says, is that interest rate risk dominates the fixed income market, and it dictates more than 98% of the risk/reward behavior. Interest rate risk is the risk that an investment’s value will change because of a change in the absolute level of interest rates or any other interest rate relationship there is, according to Investopedia. As interest rates rise, bond prices fall, and vice versa.

“If you don’t measure it clearly and correctly,” he says of the interest rate, “it’s not a good index.”

Ryan says that bond indexes with broad maturity ranges, such as a 1-10 year or a 20+ year, often produce vague or misleading calculations of the interest rate risk which might then lead an investor to be more risky than he or she ordinarily would be.

The second problem is that many bond indexes are market-weighted indexes of seasoned bonds that don’t accurately show the projected risk/reward of any one maturity. By market weighting, Ryan says, it skews the data toward the largest market weight.

There are also issues with, among other things, putting callable bonds in a maturity-defined index (they can be priced to a termination date that is outside the index’s maturity range), and the fact that issues come in and out over time, resulting in volatile summary statistics.

“They’re like garbage cans, where any new issue with those criteria go into the index,” Ryan says. The result is that over time, as issues come and go, it’s not clear to an investor just what the index looks like.

After realizing the problems with bond indexes, Ryan set out to fix it himself by looking around at other indexes. Some are weighted by dividend. Some are weighted by several factors. “Who knows which one’s the best? There are many ways to do it,” he says.

When it comes to bond indexes, “I believe you have to equal weight it. If you don’t know the market-cap weight, you should equal weight, or the data will be a distortion.”

His ETFs, issued through Ameristock and PowerShares, are all based on fundamental bond indexes. “These ETFs hopefully represent fundamental indexes and a solution to the traditional problem with bond indexes.”

By limiting the indexes to the most liquid issues available, only the largest bonds get in. And bonds are also limited in their percentage weightings in the index. In traditional indexes, Ryan says, bonds with the worst credit often are a greater percentage of the index. “We’re very cautious on credit risk.”

The available funds are:

• Ameristock/Ryan 1 Year Treasury (GKA)
• Ameristock/Ryan 2 Year Treasury (GKB)
• Ameristock/Ryan 5 Year Treasury (GKC)
• Ameristock/Ryan 10 Year Treasury (GKD)
• Ameristock/Ryan 20 Year Treasury (GKE)
• PowerShares 1-30 Laddered Treasury Portfolio (PLW)

Tags: Bond ETFs