Joe Bracken looks at the limitations of the MSCI World Index as a benchmark for global returns and argues for an equally-weighted portfolio to achieve diversification.
It’s no surprise in today’s low inflation environment that hungry investors are looking offshore for yield.
While offshore markets are undoubtedly volatile, savvy investors recognise that opportunity also abounds.
Global equities can play an important role in diversifying your clients’ risk and returns. Indeed in the past few years, they have performed very well.
The benchmark for global returns – the MSCI World Index – has been the dominant benchmark for global equity investing for 50 years.
However, there is more to global equities than just the MSCI World Index despite its dominance as a benchmark. This article looks at the limitations of the MSCI’s underlying approach known as market-cap weighting, and how you can achieve better beta for your clients by reconfiguring this model.
Better beta comes into fashion
Market capitalisation has long reigned as the most popular model of portfolio weighting. If you’re an investment manager looking for the most efficient form of beta, there is a good chance your global equity portfolio is managed against a market-cap weighted benchmark – usually the MSCI World Index.
But this index was developed nearly 50 years ago, and despite the changes in economic conditions over the years the index remains largely unchanged.
The nature of equity investing began to shift in the 1990s. Investment managers began asking themselves about weighting schemes, and pondered whether traditional market-cap weighting schemes were up to the job.
While many new weighting schemes were proposed, they all had to meet five criteria to be considered as replacements for the traditional market-cap weighting scheme:
- Diversification – does the new weighting scheme result in sufficiently diversified beta?
- Performance – does it have robust performance over time?
- Theory – what market factors are being exploited and what investment theory is at work?
- Liquidity – does the new weighting scheme provide sufficient liquidity?
- Transparency – is it easy to understand?
Tempo believes that an equally weighted portfolio construction scheme is the most effective approach, and answers all these questions favourably.
An equally weighted approach invests in a number of markets on an equal basis rather than using a market’s capitalisation.
An equally weighted scheme results in greater diversification and better performance over time, and there is sense in implementing both approaches to complement an investment strategy, rather than simply replacing one with the other.
Diversification
Despite all the changes to the world economy in the last three decades, the MSCI World Index has barely moved in its composition: the US, UK and Japan account for around three-quarters of it.
While the MSCI World Index may seem like a good snapshot of global performance, in reality it is far from being the ‘world’.
This heavy concentration on just three markets can have a negative impact on portfolios, whereas diversification delivers better risk-adjusted returns.
An equally weighted approach results in better diversification and a truer ‘world’ index.
Performance
Performance is the main game when it comes to capturing beta, and Tempo’s analysis shows that equal weighting delivers better results than a market cap weighed approach over time.
An analysis of performance at a country level between 1990 and 2014, shows the equally weighted MSCI World outperforming its market-cap weighted one over time.
Grounded in theory
In addition to better diversification, the strength of equal weighting comes from two other important attributes.
The first is the exploitation of market factors – in this case, the ‘smaller country’ premium, that shows mid-to-small countries’ markets perform better over time.
The smaller country effect can be demonstrated by Tempo analysis that splits the MSCI World Index into large and small countries, and shows on average, since 1975, smaller markets have outperformed their larger peers.
The second is a diversification premium – the extra return you pick up by having your bets spread across more countries rather than just concentrated in three. Extra returns through better diversification can be demonstrated at both a country and a stock level.
Sufficient liquidity
Market-cap weighted benchmarks are popular in large part because of their liquidity. For equally weighted portfolios, liquidity could be an issue at a stock level (as it gives equal weight to the smallest and least liquid stocks); however the same issue cannot be said on an index level.
Equities indices are highly liquid, with the wide availability of cheap, exchange traded instruments.
Highly transparent
Some weighting schemes can become unwieldy under the burden of complexity. An equally weighted scheme is simple and transparent.
Advisers looking to provide clients with exposure to global equities have a range of index-linked approaches to choose from to generate long-term growth.
On balance however, an equally-weighted portfolio delivers better investment outcomes across a range of areas, and provides a good base on which to build a better beta scheme.
Joe Bracken is a principal at Tempo Asset Management.
