Etf Portfolio: Weighting According To Gdp Or Market Capitalization

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If you want to put together a global equity portfolio from exchange-traded index funds (ETF), you have to decide how the individual countries should be weighted. For four decades in a row, it was advantageous to structure the depot according to economic output measured against gross domestic product (GDP). But since 2010 the tide has turned. It is good form among digital asset managers and fund of funds managers to weight the equity component of ETF portfolios according to the economic performance of the countries they contain. The country exchanges with the highest market capitalization also have the greatest weight in the MSCI World. If the prices of companies in one country rise faster than in the other countries, its weight in the index increases, while the share of the other index components decreases.

What does a GDP weighting bring?

Overall, a weighting based on the share of countries in global economic output appears somewhat more balanced. But is GDP weighting actually more beneficial? Asset managers who promote this concept often use the following arguments:

  1. The diversification is better.
  2. The return is higher.
  3. A GDP weighting avoids so-called cluster risks and therefore dampens the consequences of stock bubbles.
  4. In contrast to the concept of market capitalization, weighting according to relative GDP takes better account of the real economic relevance of the individual countries.

Are GDP-Weighted Portfolios Really Better Diversified?

In the case of risky asset classes , the degree of diversification is usually linked to the level of volatility . The lower the fluctuation range, the more diversified an equity portfolio is. Another indicator is the maximum loss in value within a certain period, whereby a low volatility does not mean that the maximum loss in value is also low. Portfolios with high volatility may experience lower maximum losses than portfolios with lower volatility. Neither the volatility nor the secondary maximum losses were systematically lower. Rather, the picture changed over the decades. Over the entire study period of almost 50 years, market capitalization and GDP weighting were almost the same.

Rebalancing between risky asset classes often increases returns

Another factor that causes differences in returns between the index weighted according to market capitalization and the portfolio based on economic performance is what is known as rebalancing . The portfolio components are regularly reset to defined weightings.

While the GDP and the equally weighted portfolio have to be regularly rebalanced, the country shares in an index weighted according to market capitalization fluctuate unhindered with the respective price development. In this way, the size of the respective exchange is automatically taken into account. Rebalancing between risky investments such as equity ETFs on different country exchanges often leads to higher returns compared to a portfolio that is not rebalanced, various studies show. You can read more about this in our analysis of the rebalancing of portfolios. The often higher returns of small companies compared to large corporations in the past are also likely to have boosted the returns of the GDP-weighted and equally weighted portfolios. In the latter in particular, small caps have a higher share than in the classic MSCI World.

Does GDP Weighting Curb the Impact of Equity Bubbles?

Typical of price bubbles on stock markets is a decoupling of the stock exchange from real economic performance . The market capitalization in relation to GDP is increasing significantly. That was the case in Japan in the 1980s.

However, such a price development has no influence on the country weighting of a portfolio structured according to GDP. The investments that were not weighted by market capitalization gained from their limited share in Japan when the bubble exploded in Japan in the early 1990s. They suffered less from the extremely poor price development in the East Asian country.

Do investors with a GDP-weighted portfolio participate better in the development of high-growth countries?

This argument is aimed primarily at the emerging markets . The share of many emerging countries in world GDP has risen sharply in recent decades. But the local stock exchanges are lagging behind this development. The market capitalization of the shares in free float, which is decisive for the country weight in traditional indices, is still low. In the opinion of many asset managers, emerging markets are therefore underrepresented in world indices such as the MSCI All Country World Index . This may apply to countries in which the free float is very low, for example because the state holds large shares in listed stock corporations that are not available for trading.

Hello, I have been working as an investment consultant and author for more than 20 years. I love what I do and I have enriched everyone around me. A lot of money is not important, the main thing is how you use the money.

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