Question

Finding the Optimal Weighting Scheme for International Portfolios

Just as with domestic portfolios, when investors manage international portfolios they need to construct a benchmark, or index, portfolio against which they can evaluate performance. The issue of weighting the relative importance of the national components of an international index portfolio is a point of debate among financial market experts. Some argue that the sizes of national economies, as measured by their respective GDP, should define the weights, while others support the choice of their relative market capitalization, and still others propose the use of each economy’s value of imports.

In this week’s Discussion, you will join the debate and argue for and against each of the possible weighting schemes proposed above.

To Prepare

Review this week’s Learning Resources, as well as other resources you may access from the Library and the Internet.

Consider the following:

What are the advantages and disadvantages of using the market capitalization of each economy in weighting an international index portfolio?

What are the advantages and disadvantages of using the GDP of each economy in weighting an international index portfolio?

What are the advantages and disadvantages of using the value of the imports of each economy in weighting an international index portfolio?

Post by Day 3 a 3- to 6-paragraph assessment that compares and contrasts the most appropriate weighting scheme for the construction of an international index portfolio. Please make sure to include responses to the following specific questions:

Which one of the three proposed weighting schemes is more prone to produce weights that change substantially over time?

How do exchange rates affect the choice of the best weighting scheme. Why?

How might geopolitical alliances and conflicts affect the stability over time of the weights under each scheme?

Please address clearly each of the questions in 1–2 paragraphs. Make sure you use APA style for your response(s) and properly cite any resources you have used.

Answer 1

To Prepare:

1) What are the advantages and disadvantages of using the market capitalization of each economy in weighting an international index portfolio?

A capitalization-weighted index is an index whose components are weighted according to the total market value of their outstanding shares. The impact of a component's price change is proportional to the issue's overall market value, which is the share price times the number of shares outstanding.

Advantages:

There are many reasons why market-cap-weighting has been the dominant standard for stock market indexes.

• First, market-cap-weighted indices offer an objective way to describe the composition of the opportunity set using capitalization as the proxy for size.
• Second, they are relatively simple to calculate since the weightings of index components automatically adjust as stock prices change daily. Market-capweighting is also consistent with a passive buy and hold strategy.
• Third, the weighting scheme favors stocks with higher trading liquidity and capacity since it tilts towards larger companies.

Disadvantages:

• In the presence of price inefficiency and mean reversion, the capitalization weighting scheme can be less than desirable when price bubbles and other temporary price disequilibria will affect weights.
• This may result in performance drag and volatility of security and sector weights resulting in excessive volatility in returns.

2) What are the advantages and disadvantages of using the GDP of each economy in weighting an international index portfolio?

Market-cap-weighted indices reflect the available investment opportunity set in public equity markets. By design, they ignore any unlisted companies, whether privately held or state-owned, since these are not accessible to the investing public. One of the oldest alternative weighting schemes is one that weights countries by their Gross Domestic Product (GDP). Consequently, the weights of countries in the GDP-weighted index will represent the relative importance of a country’s economy as opposed to the size of its equity market.

Later, the GDP-weighted indices were extended to cover emerging markets. Within emerging markets, weighting based on economic size rather than market capitalization was a way to address the divergence between economic size and market size of many countries with the faster growing economies. The idea was that developing countries would progressively adopt market-oriented policies in a globalizing world.

The GDP-weighting scheme overweights (underweights) countries with economic weight greater (smaller) than the market capitalization weight. According to the MSCI GDP weighting methodology, the weights of the countries in the index are set in May of each year to each country’s nominal GDP as a percentage of the total. Between the May rebalancing, the country weights naturally evolve with changes in the countries’ prices and market capitalizations.  

Advantages:

• The main advantage of GDP weighted indexes lies in the simplicity of their construction. GDP weighted indexes also have a long historical track record, which facilitates investment research. For example, the DJIA was first published in 1896.

Disadvantages:

• GDP weighted indexes are overly influenced by the highest-priced securities because they have greater weights in the calculation of the indexes' returns. Because GDP weighted indexes weight by price instead of total market value, they do not necessarily reflect the economic importance of issuing companies.
• Stocks that appreciate often experience stock splits, and their weights in the index will decrease. Successful companies will become underrepresented, creating a downward bias in the index return.
• GDP weighted indexes assume an investor holds one unit of each security in the index, which does not describe how most investors form portfolios.

3) What are the advantages and disadvantages of using the value of the imports of each economy in weighting an international index portfolio?

Advantages:

• The proponents of Import weighted indexes argue that capitalization-weighted indexes overweight overvalued issues and underweight undervalued issues. Fundamental-weighted indexes seek to avoid this problem by using valuation metrics, rather than market value, to weight index constituents. Proponents also assert that these indexes will be more representative of an issuer's importance in an economy because they weight by fundamentals, rather than by market prices subject to bubbles.

Disadvantages:

• A disadvantage of import weighted indexes is that they reflect the index creator's view of valuation, which may or may not be correct. The fact that there are different methods of constructing import weighted indexes in the industry demonstrates that they rely on subjective judgment.
• A second disadvantage is that they may be less diversified than capitalization-weighted indexes if the valuation screen is restrictive.
• Third, as mentioned previously, not all investors could hold a import weighted index because they are weighted by valuation metrics, not by available liquidity (market capitalization).
• Fourth, the construction methodology used by these indexes is usually proprietary because they are created to market a import weighted fund. In this case, these indexes would not serve as valid benchmarks because their composition and weightings are not fully known.
• Fifth, just because import weighted indexes have outperformed capitalization-weighted indexes in certain past time periods does not mean they will in the future and, more importantly, does not indicate that they are useful indexes. As a reflection of "how the market did," an index should be judged on whether it is a representative sample, not on its performance. It is active management that is intended to deliver superior performance, not indexes. Index performance should be an outcome of index construction, not an objective. Furthermore, the reason why import weighted indexes have outperformed historically is that they are usually tilted toward small-cap value stocks, a well-documented effect in academic literature. For investors preferring a large-cap or growth emphasis, import weighted indexes would not serve as ideal benchmarks.

Most appropriate weighting scheme for the construction of an international index portfolio:

Using the market capitalization of each economy in weighting an international index portfolio because:

• Weighting companies by market value is an objective way of measuring the relative importance of constituents, as it clearly measures the market's assessment of their relative values. A security's price is a consensus estimate of its value formed by a multitude of investors, rather than a single index creator's estimate. Market prices and the number of tradeable securities are unambiguous measures of value at a point in time.
• A capitalization-weighted, float-adjusted index is the only index type that all investors could hold. If all investors held all the securities in cap-weighted indexes in proportion to their market value, then all shares would be held, with none left over. This property has been referred to as macro consistency (Siegel 2003). With other weighting methods, such as fundamental-weighted indexes, not all investors could hold the index. A cap-weighted index is thus the best representation of a typical investor's opportunity set. As a result, a capitalization-weighted index is superior at succinctly representing the effect of changes in a market's total value and investors' total wealth.
  This property is closely related to one of the central results of the original capital asset pricing model (CAPM): Under the assumptions of the CAPM, a cap-weighted portfolio of all assets is efficient, and all investors in a CAPM world would hold a proportional investment in the market portfolio. A cap-weighted index reflects this concept.
• A capitalization-weighted index requires less rebalancing than other indexes. In value weighting, changes in prices do not create a need to add or remove shares; the index remains cap weighted after a change in price. The capitalization-weighted index also self-corrects for stock splits because they are reflected in the number of shares outstanding and price per share. If an investor tracks a capitalization-weighted index and there are no changes in the index constituents, then the portfolio will automatically track the index and no rebalancing is necessary. Other weighting schemes require periodic trades to bring the weights back to those required by the scheme.

*Also a comparison between using market capitalization over value of imports has been shown in the disadvantages section of the using value of imports*