The Case For GDP-Weighted Equities

May 24, 2010

If you own a traditional, market-cap-weighted index fund, you currently have 50 percent more money in Switzerland than you do in
China
. Seems crazy, doesn’t it?

After all, China’s economy is 10 times larger than
Switzerland’s, and growing faster as well. Wouldn’t you expect
China
’s weight in global equity indexes to dwarf that of the alpenhorn-blowing, private-banking Swiss?

Van Eck recently filed papers with the Securities and Exchange Commission to launch two exchange-traded funds that will give investors an alternate—and attractive—approach. The Market Vectors GDP International Equity Index ETF and Market Vectors GDP Emerging Markets Equity Index ETF are linked to indexes that use gross domestic product rather than market capitalization to determine where to invest. (We reported on Van Eck’s plans on May 13.)

While I’m usually a traditional, by-the-book, market-cap-weighted index investor, I find the GDP concept appealing.

Free-Float Weighting

To understand why, you have to step back and think about how modern market-cap-weighted indexes are calculated.

Consider, for example, the MSCI All Country World Index. As the name suggests, the ACWI aims to capture the performance of all investable equities in the world. It is one of the most popular global indexes and the benchmark for the $1 billion iShares MSCI ACWI ETF (NYSEArca: ACWI).

To create this index, MSCI sums up the market capitalizations of all companies traded on major exchanges around the world. It then adjusts these market capitalizations for “free-float,” which means it only counts shares that that are freely traded: Shares held by insiders and government institutions are not counted. Once this free-float adjustment is made, each security is weighted based on its share of the total global market cap.

The rationale for free-float-weighting is simple and convincing. Indexes that follow this strategy will capture the experience of the average dollar invested in the global market. They will neither underperform nor outperform the average. Buy this index at the lowest possible cost and you’ll beat the majority of investors.

But the free-float system isn’t perfect. It introduces two biases that investors should consider.

First, it skews the portfolio toward countries with well-developed capital markets. That means markets like the U.S. and the United Kingdom have large weights relative to the size of their economies, while countries with less developed capital markets like China and
Brazil
are underweight relative to the size of their economies.

Second, it skews the portfolio away from countries with large insider holdings. This particularly impacts countries whose largest companies were recently privatized after years of government ownership, such as China and
Russia
.

The table below shows the weight of different countries in the market-cap-weighted MSCI ACWI versus GDP weights according to the 2009 CIA Factbook. Developed markets, and particularly English-speaking markets, have much higher market-cap weights than GDP weights, with the
U.S. “overweight” by more than 13 percent on a GDP basis.
China
, however, is dramatically undercounted, registering just a 2.1 percent weight in the ACWI while representing 9.8 percent of global GDP.

 

Market Cap

GDP Weight

US

41.95%

28.49%


Japan

8.92%

10.13%


UK

8.69%

4.36%


Canada

4.21%

2.67%


France

3.99%

5.35%


Australia

3.35%

1.99%


Germany

3.15%

6.70%


Switzerland

2.97%

0.99%


China

2.09%

9.81%

 

 

If you exclude the
U.S.
, the results are even more dramatic. The market caps of the U.K., Canada and Australia are massively out of line with GDP weights, while Germany, China and
Brazil
get a bump from GDP weighting.

 

Market Cap

GDP Weight


Japan

15.73%

10.81%


UK

14.78%

4.66%


Canada

7.06%

2.85%


France

6.69%

5.71%


Australia

6.47%

2.13%


Germany

5.97%

7.15%


Switzerland

5.39%

1.06%


China

3.81%

10.47%


Brazil

3.28%

3.36%

Over almost any time period you look at, the GDP-weighted indexes have outperformed their market-cap weighted peers. MSCI has been producing GDP-weighted indexes since 1988, and since that start date through November 2009, the GDP-weighted MSCI ACWI has outperformed its market-cap-weighted peer dramatically, delivering 7.4 percent annualized returns versus 4.7 percent for the market-cap benchmark.

Focus down to the MSCI Emerging Markets index and the difference is even larger: the GDP-weighted version has delivered 14.5 percent in annualized returns versus just 9.6 percent for the market-cap-weighted benchmark.

Both have done so while adding only a small measure of additional risk.

According to the MSCI study that serves as the source of the performance data, GDP-weighted indexes show little style, sector or index bias compared to market-cap weighted peers. Instead, “GDP weighting seems to be an active bet on the country and currency factors, allocating more to emerging markets and less to developed markets,” it says.

In today’s market, it may be an active bet worth making.

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