Growing Disconnect: Market-cap Weighted Indexes and the GDP Share of China

Jul.16.07 | About: Vanguard FTSE (VEU)

A Wall Street Journal article this morning got me thinking about the growing disconnect between market-cap weighted indexes and the GDP-share of emerging economies, and in particular, China.

China, according to the article, is set to surpass Germany as the world's third-largest economy sometime this year. Right now, China has an annual GDP of $2.8 trillion versus Germany's $2.9 trillion. (The U.S. GDP is $13.2 trillion, followed by Japan at $4.4 trillion.) With China's superior growth rate (11% vs. 3%), the country will speed by Germany later this year and will trump Japan before long.

Because China's stock market is still in its infancy, however, its share of global GDP is quite small: In the Vanguard FTSE All-Word Ex-U.S. ETF (AMEX: VEU), China merits just a 2.0% weight, compared to 6.4% for Germany. In all, nine countries separate the two, including The Netherlands, Sweden, Australia and Italy. South Africa is nipping at China's heels with a 1.6% weight.

Back in the 1980s when Japan's equity bubble was in full flower, MSCI introduced a GDP-weighted version of the MSCI EAFE Index for investors who were uncomfortable having an inflated allocation to Japanese stocks.

I'm surprised there isn't more call for GDP-weighted international index funds and ETFs (I know that these strategies exist, but they aren't popular with main-line investors). Or, to take things a step further, an equal-country-weight ETF that rebalances regularly. I'm not saying these would be good investments, but I could imagine a product developer making the case for the products.

[BTW: People like to say that GDP-weighted indexes are akin to the Fundamental Indexes and other alternative weighting strategies. I'm not convinced. Those strategies look within the stock market and attempt to "correct" for perceived flaws inside the market structure, suggesting that investors mis-judge the market and that an alternate weighting strategy will do better. GDP-weighting does not look down on the judgment of investors; instead, it attempts to correct for perceived weighting flaws generated outside of the market structure.]