Deflation may briefly take hold in the US in the next six to 12 months, which will spark additional stimulus, heighten the risk of inflation and reduce the value of inflation-linked assets, creating a "wonderful buying opportunity" for those products. So says Robert Arnott, founder and chairman of Research Affiliates, an investment manager based in Newport Beach, California.

The US faces a serious risk of a policy-induced second downturn, which would have a significant impact on the world economy, he says. "The path the US has chosen almost guarantees significant inflation as the only cure to our level of indebtedness," said Arnott during a trip to Hong Kong in December. "It means that major inflation three to five years from now becomes the politically expedient way to deal with too much debt."

So how would such a situation play out in the markets? "Tips [Treasury inflation-protected securities] would be fine," he says. "Surprisingly, below-investment-grade maturity debt -- bank leveraged loans -- would do okay, because short-term instruments have an inflation kicker in them."

As for high yield, inflation would cause the real value of such debt to fall, meaning the ability to repay would improve and the "quality spread" compresses, creating capital gains on top of the high yield, he says. In fact, leveraged loans are more highly correlated with the Consumer Price Index than commodities, adds Arnott, who says commodities themselves would also be an interesting inflation play.

Many of these assets will be more interesting to investors in the next 12 months than they are today, he says, because the next reports of inflation will be deflationary. But many agree that while global deflation is a more immediate threat than inflation, it is a likely outcome further down the road, and investors are taking that into account in their strategies.

Yet all this doesn't get away from the central problem -- the massive level of US debt. US debt is nominally 80% of GDP, Arnott points out. But add in state and local and the government-sponsored entities (such as mortgage finance agencies Fannie Mae and Freddie Mac), and aggregate public debt reaches 140% of GDP.

"People don't look at that number, most people don't even know it," he says, adding that the 140% debt-to-GDP ratio is only exceeded by three countries: Japan, Lebanon and Zimbabwe.

Moreover US household debt is the highest in the world, at 100% of GDP; corporate debt is the highest globally, at 320% of GDP; and total debt is the highest in the world, at 560% of GDP, rising to 840% once unfunded future liabilities such as Medicare and social security are included.

Arnott is the creator of the Fundamental Index methodology and, together with index provider FTSE, developed the FTSE-RAFI Index Series (FTSE-RAFI). The product addresses the issue whereby traditional capitalisation-based indexing strategies systematically overweight overpriced securities and underweight underpriced securities.

When asked for his predictions on FTSE-RAFI returns for 2010, Arnott says he doesn't have a view on overall returns so much as relative returns. He suggests FTSE-RAFI will outperform cap-weighted markets, such as MSCI indices and the S&P 500, by a decent margin over the next three to five years.

Arnott cites the fact that the tech bubble bursting in 2000 set the stage for seven years of value strategies beating growth strategies by an average of 6.5% a year. "And FTSE-RAFI beat value, in a value-dominated market, by an additional 1%," he adds. Given that valuations are stretched almost as much as in 2000, Arnott says he is highly confident that over the next three to five years FTSE-RAFI will outperform cap weighting by a good margin.

Another issue with the cap-weight approach, he adds, is that "by mirroring the swings of investor expectations, it winds up making some pretty peculiar bets".

He points out that the FTSE-RAFI All World 3,000 index is currently weighted 33% US and 3% China, while the MSCI ACWI is 44% US and 2% China.

Arnott says cap weighting is effectively suggesting that US growth will be better than that of the rest of the world by enough to justify a 10% overweight relative to the scale of US businesses. "Where's the sense in that?" he says.

Cap weighting also suggests that China's growth potential is lower than the rest of the world's by enough to justify two-thirds as much of an allocation relative to the country's publicly traded scale of business. "How can that be?" says Arnott.

FTSE-RAFI doesn't second-guess the cap-weight bets, he adds, it simply uses company size or country size as its "anchor for rebalancing". "And whatever swings the market makes," says Arnott, "FTSE-RAFI rebalances and contra-trades against the nonsense; against bubbles and anti-bubbles."

Meanwhile, FTSE has been working with Research Affiliates over the past few years and currently has several asset owners in the Asia-Pacific region implementing the FTSE-RAFI passive strategy in their portfolios. There are several other asset owners in Australia and Japan with significant assets invested into this strategy, and traction is increasing.

In addition, Beijing-based Harvest Fund Management recently launched a fund based on the CSI-RAFI 50 index, which raised more than Rmb3 billion ($439.3 million) in its first 10 days. Last year, French asset manager Lyxor listed two exchange-traded funds on the Hong Kong Exchange based on the FTSE-RAFI US 1000 and FTSE-RAFI Europe indices. And Seoul-based Korea Investment Trust Management Company offers several retail funds based on FTSE-RAFI indices.