Know The Geography Of Your Index

Due diligence. Another buzzword, but a very important one, in the ETF industry. Investors and financial planners are heavily encouraged to drill down into their passive funds to analyse a plethora of factors: tracking performance/error, bid/ask spread and liquidity, currency risk, headline fees and trading cost, replication method – and the index.

Certain revelations may be surprising. Altaf Kassam from indexer MSCI pointed out this week that the turnover of smart beta indexes is between 20-30 percent every year, compared to a broad market cap index turnover of 5-6 percent. This is a startling figure because the more the turnover in the fund, the higher the end cost for the investor.

Examine your geographical exposure

But what about the geography of the index? This point is often left out. Home bias might tempt UK-based financial advisers to stick to the FTSE 100, and not be aware that this index is becoming an increasingly global benchmark as UK-based firms derive ever-greater proportions of revenue from overseas.

The other point economists might make is that the UK economy might not be directly linked to its main equity index – after all the FTSE 100 has reached yet another record high of 7106 points this week, despite the recent depreciation of sterling and inflation stagnating at zero.

A domestic or global fund?

The subject of geography came to light this week when I was interviewing Lars Hamich, CEO of fund provider Van Eck Global Europe, who was talking about the company's two new London-listed gold miner funds. “Where are gold miners based?” I asked, slightly confused, as I saw “Canada” listed as over half of the fund.

The answer – West Africa, Peru, Mexico – came as a surprise, and is a perfect example of not taking the factsheet too literally. What first appeared as a fund heavily biased to Canada and North America was in fact a truly global product.

The source of company revenue will naturally depend on the company itself and its sector. While energy producers and miners might have most of their operations abroad, and then sell their ware to even more far-flung corners of the world, a consumer staples company like Johnson & Johnson will sell a bigger chunk of its products to its home market. Apple may be a U.S.-founded company, but look out for headquarters in Ireland where it can benefit from tax arrangements and direct profits and revenues in a flexible fashion.

Investors would have to head further down the scale to mid caps (e.g. the FTSE 250) and small caps to get a more accurate representation of their domestic economy.

Concrete evidence

Searching for more concrete answers, I was delighted to stumble across the Edhec Risk Institute’s recent report on geographic exposure of indexes, published last month.

See below for Edhec’s table of regional exposure of developed market indexes, based on a breakdown of sales from its constituent companies. The index data is from 2013, with sales data taken from the fiscal year of 2012.

*Source: DataStream (Worldscope), supplemented by Bloomberg

I knew the FTSE 100 had a strong chunk of earnings overseas, but I did not know it was less than half – and that’s 49 percent in Europe as a whole, not just in the UK. So much for main equity indexes acting as the bellwether for a country’s economy.

Furthermore, this percentage has decreased significantly from 58 percent in 2003 as we live in an increasingly globalised world, as shown in the report. The same trend can be seen across the other indexes: for example, the S&P 500 used to have more than 80 percent of earnings derived in the U.S. in 2003, and that has decreased to 73 percent.

And what about if we take the same indexes and compare developed versus emerging market exposure for the same time period?

Again, the FTSE 100 used to have only 9.55 percent exposure to emerging markets, and in 12 years has jumped to over 22 percent, as laid out in the report.

Of course there are other index factors to consider, such as the underlying companies or securities themselves, how concentrated the index is, and how often it rebalances, and what currency it tracks. However, geography tells you a lot about your exposure too.

“It would be a shame if asset allocators compromised their asset allocation policy, which is often based on macroeconomic scenarios that use regional dimensions, through poor evaluation of the geographic reality of their portfolio or benchmark,” says Edhec.

I couldn’t sum it up better myself.