Clay Carter examines the MSCI World Index and explains why investors need to consider a benchmark unaware approach to portfolio construction.
As we enter the second decade of the 21st century, the majority of global investors, researchers and consultants still use the MSCI World as their global benchmark.
As a standard that supposedly captures global equity markets and underlying economies, there are arguments that it is woefully inadequate in reflecting current economic forces, global growth and market composition.
More than 95 per cent of the MSCI World is made up of developed markets and stocks. The US market alone represents 55 per cent, Europe and the UK account for some 30 per cent and Japan 10 per cent.
Unfortunately, this configuration ignores the fact that over the next decade more than 60 per cent of global growth will come from the so called 'emerging world': China, Brazil, India and (perhaps) Russia.
Smaller high growth regions such as Indonesia, Taiwan and Korea will also contribute. All of these markets are substantially underrepresented by this index.
The Chinese economy, in terms of total size, is expected to eclipse that of the US before 2020, according to the latest PricewaterhouseCoopers report, The world in 2050.
India, currently growing at more than 8 per cent, has the potential, by virtue of positive demographic trends, to overtake China by 2050.
Forgetting about the future, auto sales in China are running at 20 million units per annum — in the US we’ll maybe see 12 million in 2011.
As well, the fiscal predicament of the major G7 economies is not pretty.
Public debt as a percentage of gross domestic product is expected to expand from 90 per cent to 110 per cent over the next few years, while the public deficits of emerging economies will likely decrease from 37 per cent to 34 per cent.
Forecasters estimate that G7 gross domestic product (GDP) growth will average approximately 2.1 per cent per annum to the middle century and that their contribution to G20 GDP will contract from the 72 per cent seen in 2005 to 40 per cent in 2050.
In contrast, the so called ‘big five’ of the G20 nations (Brazil, Russia, China, India and Mexico) will see their share of G20 GDP rise from 19.6 per cent to 51 per cent before the middle of the century.
This poses the question: Why should anyone allocate 95 per cent of their assets to regions that are heavily in debt and experiencing weaker relative growth?
That the ‘big five’ developing countries will cause a significant seismic shift in the world economy is hardly a new view.
As early as 1997, the World Bank detailed this phenomenon in its ‘Global Economic Prospects’ publication, while the term ‘BRIC’ was coined and the potential for these countries to transform the world’s economic landscape economy examined by Goldman Sachs economist Jim O’Neill in 2001.
Why then do the majority of global investors still invest like its 1999? And what are the implications of adhering to such an outdated, unrealistic strategy?
For users of the MSCI World, stock selection is held hostage by size and location.
Excess returns tend to suffer, as the user has to hold not only large ‘benchmark’ stocks but is forced into a regional allocation that may not represent current opportunities in the global economy.
This may be the cause of the rather broad dissatisfaction of many global investors (currency headwinds excepted) and the relative unpopularity of the asset class in Australia. This problem is not restricted to active investors, global exchange-traded funds and index funds also suffer for the same reasons.
So what should investors do? Allocate all their overseas investments to emerging markets? Their economic governance, both fiscal and monetary, has vastly improved, and this combined with demographics and the creation of a vast middle class augur well for sustained economic growth.
However, GDP growth and market returns do not necessarily go hand in hand (in 2010 China’s economy was growing at 9 per cent but its stock market fell 14 per cent) and emerging market funds can suffer from the same structural inconsistencies as the MSCI World.
In addition, many pure emerging market funds contain biases towards certain commodities by virtue of their benchmark constituents.
Many innovative companies in technology (like Apple) and other fast growing industries such as biotech are not represented, nor are the high quality global industrials like Caterpillar or Deere.
Investors could choose a manager or product that uses the MSCI ‘All’ World index as a benchmark, but while 14 per cent of it is made up of the developing world, it still does not encapsulate the new economic realities of the 21st century by virtue of its disproportionate weight toward the ‘old world’.
Complicating the whole process is the tendency of asset consultants and researchers to ‘pigeonhole’ markets into ‘developed’ and ‘emerging’.
The reality is that ‘emerging’ markets emerged long ago and the only emerging markets left are those designated as ‘frontier markets’, such as Nigeria, Kazakhstan, Sri Lanka, Cambodia, Bangladesh and so on.
After all, what is the difference between Singapore and Mexico? Hong Kong and Korea? Absolutely nothing whatsoever, they are just ‘markets’ with strengths and weaknesses, good companies and bad.
Consider, too, some of the so-called emerging market companies like America Moviles (Mexico), CNOOC (China), Petrobras (Brazil), Severstahl (Russia), Taiwan Semiconductor (Taiwan) and Infosys (India).
They have market capitalisations ranging from US$20 billion to US$230 billion and compete on a global basis alongside their developed market peers.
Focusing on the BRIC countries for a moment, these countries present a long-term investable theme that should not be ignored by investors.
Of course, the underlying assumptions can only come to fruition by virtue of free and open markets, no significant protectionism in trade and sound macroeconomic policies.
In fact, I view the rise of the BRICs as fundamentally positive for the G7, in that it will create further opportunities for developed world players to expand their revenue base and keep per capita incomes stable at home.
While their share of global growth may be reduced, that does not mean G7 economies are in a secular decline or that the companies in their markets will not benefit.
The US, Europe and Japan all have significant global players in their markets that are experienced in expanding and developing their businesses worldwide.
A handful of forward thinking global investors and fund managers have chosen not to view the world by regions or size of the market, but through the prism of the companies themselves — no matter where they may be.
An important aspect of this is that of not differentiating between other arguably obsolete terms such as ‘developed’ and ‘emerging’.
Investors should consider globalisation and the ever-changing landscape of economies around the world and the subsequent impact of using potentially outdated benchmarks when looking to invest in global shares.
A benchmark unaware approach to portfolio construction is one that should allow investors to capture what could be the most significant global economic event since the advent of the Industrial Revolution, and it is certainly one global investors should not ignore.
Clay Carter is head of international equities at Perennial Investment Partners.
