A whole branch of theory of efficient markets has argued that it is efficient to allocate your
money based on the amount of securities outstanding. The more debt a country has, the more
weight they get in the index. As we have seen with Greece, this can lead to an unsustainable
spiral of debt, followed by a sudden default. This paper examines whether net foreign assets, a
measure of a country’s net wealth, can reliably predict future defaults and concludes that
allocating to countries with net wealth, rather than net debt, leads to superior returns for fixed
Bond indices are constructed using the amount of securities outstanding and therefore gives a
disproportionately high weight to the most indebted companies and countries. As countries and
companies become more indebted, their weight in these indices tends to rise. Left unchecked,
this would result in significant defaults in portfolios of bond investors who track indices
closely. However, this effect ought to be mitigated if rating agencies were to downgrade
countries well in advance of default, giving investors time to adjust their portfolios accordingly.
However, the example of Greece illustrates that rating agencies have been slow to adjust
ratings as economic fundamentals deteriorate. In early 2009, Greece was rated A1 by Moody’s
and A- by Standard & Poor’s. Based on a long series of historical data, such a rating implies a
probability of default of considerably less than one percent within three years.