A World Market Cap Approach to Allocation

One approach to asset allocation among equities is to follow world market capitalization. Rather than investing heavily in domestic securities simply because they are familiar, the world market cap approach allocates stock assets according to the relative size of the stock markets around the world.

Investors in smaller countries such as Holland and Scotland learned long ago to invest abroad, because their wealth exceeded the domestic opportunities. Americans on the other hand have had access to large domestic markets and have been quite insular as investors until recently. But even with the major shift toward international investing of the past several years, U.S. investors are far from allocated by world market cap.

Consider the 2006 Investment Company Institute annual report which reported that U.S. mutual fund stock assets were 77.2% in U.S. domestic stock funds and 22.8% in international stock funds. That’s way up from 10 to 20 years ago, but not close to the actual world market cap by country and region.

Now consider the report by the World Federation of Exchanges [WFE] for the period ending April 2007 (excludes investment funds and some markets such as Russia). Their data indicates that the market cap of the U.S. stock markets account for only 36.4% of the world market cap of $56.4 trillion.

Looking at the three major regions as typically reported, their data indicates this allocation:

Americas - 42.4%

Asia/Pacific - 25.8%

Europe, Africa & Mid-East - 31.8%

Reformatting to align with the MSCI U.S., developed markets of EAFE and emerging market indices, the WFE data indicate this world market capitalization [all ETFs mentioned are proxies]:

United States - 36.3% (IWV)

EAFE - 44.0% (EFA)

Emerging - 19.7% (EEM) or (VWO)

The emerging markets were less than 10% just a few years ago, but their explosive growth has dramatically changed the picture. Reasonable extrapolation of current relative earnings growth rates will see those allocations tilt even more to the emerging markets. We’ll probably have to stop calling some of them emerging in the not too distant future.

The EAFE complex is substantially as follows:

Traditional Europe - 29.4% (IEV)

Japan - 8.3% (EWJ)

Australia - 2.3% (EWA)

Canada - 3.2% (EWC)

Singapore - 0.8% (EWS)

The emerging market complex is substantially as follows:

China - 6.9% (FXI)

India - 3.2% (INP)

Korea - 1.6% (EWY)

Brazil - 1.5% (EWZ)

South Africa - 1.4% (EZA)

Mexico - 0.5% (EWW)

All others - 4.6%

Unfortunately, these country percentages within the emerging markets category don’t line up very well with the allocation among emerging countries in the MSCI emerging markets index (see prior article)

The MSCI index is free-float adjusted and the WFE figures are not. That may be the explanation of the differences — that one measures total market wealth and the other measures the investable opportunity. It may also be due in part to measurements at different points in time, or perhaps something else. However, the major point about regional market caps is, we believe, intact in spite of the data discrepancies.

For our own account, we seek to invest as much toward where the market cap is, subject to limits as to the degree of volatility we can accept in our portfolio.

Regardless of the percentages, we recommend "core" portfolio holdings of a broad market U.S. equities fund, a developed countries international fund and an emerging markets fund. From that core it is then appropriate to tilt any or each of those three key categories toward a style or market cap or sector weights in the domestic market, and toward sub-regions or countries in the developed international and emerging markets, by adding specialist “satellite” funds..

The Latin American exchange traded fund, (ILF), and the Asia/Pacific Rim excluding Japan exchange traded fund, (EPP), are examples of ways to create a regional tilt. Individual country funds provide the other satellite funds to create tilt toward where you think the most value growth may be. However, we do not recommend abandoning the core holdings. Remain diversified and ready for the twists and turns that inevitably occur in markets.

You will want/need to review your satellite fund choices at least yearly, because they may move in and out of your favor, but you should maintain diversified core positions. You should also set an allocation policy decision for each position and rebalance to the policy allocation periodically to keep the balance of assets you selected in the first place. This also allows you to “harvest” gains instead of riding positions up and then back down again.

While there is opportunity to enhance returns by making good market cap, style (value or growth) or sector allocation decisions in the domestic market, we think that to the extent that your physical and mental time is limited, you will fare better making region and country allocation decisions most of the time. And, while correlations are converging worldwide, there is still probably lower correlation of returns between regions and countries than between domestic market caps, styles and sectors.

Tread carefully overseas, but do go there.

Full Disclosure: Author owns IWV, EFA, VWO, EWY, EWS, EWA, EWW among the securities mentioned.

Comments

[fingham:]

I think using market cap is a risky way to allocate. As Robert Arnott has shown with his "fundamentally" weighted indexes, cap weighting tends to overweight what's overvalued and underweight what is undervalued. How about looking at the fundamentals in the markets in question? GDP, or, the cumulative value of revenues, and/or dividends, of the public companies in those markets, might give a more realistic weighting criteria (Robert Arnott's other factors, book value and earnings, may be too difficult to compare from country to country due to varying financial reporting standards. Even revenue is probably not strictly comparable, but it is probably more comparable that earnings or book value). With the recent run-up in non-US stocks, particularly "emerging markets", a cap weighting is probably taking on excessive risk (despite the obvious attraction of being relatively easy to calculate).

2007 Jun 13 05:32 PM

[QVM Group:]

That is a very reasonable concern and idea. The best might be to combine the two. My key point is to be guided by, not limited by market cap. I actually do both. For example, I do not currently invest in China for example, because of overvaluation.

Perhaps I will attempt another article to integrate the idea of following the money around the world through observing market cap, while guarding your pocket book by examining fundamentals.

Thanks for the observation, I probably should have identified market cap as one tool and not the only tool.

2007 Jun 13 05:39 PM

[Tristan Yates:]

Good article. Well, the best thing about market cap as an asset allocation strategy is that it minimizes transaction costs and taxes, as it more or less rebalances itself as the asset prices change. That's pretty neat. The situations where you have a stock or sector or country that dominates the allocation, like China for example now, isn't an argument against market cap allocation but rather an argument for dollar cost averaging over long periods of time, because you could have bought China cheaply three years ago, and chances are you're buying something else cheaply today.

2007 Jun 18 06:09 PM