From time to time the weighting of certain countries within capitalisation-weighted equity indexes may diverge significantly from those countries’ share of global GDP.
An example of a dramatic divergence between a country’s global equity market footprint and its economic importance comes from late-1980s Japan. In 1989, according to the International Monetary Fund (IMF), Japan’s share of world economic output, based upon a purchasing power parity (PPP) valuation of global currencies, was just under 10 percent.
But Japanese stocks reached a collective share of over 40 percent of the FTSE World Index during the same year, reflecting significantly higher stock company valuations at the time in Japan than in other global stock markets.
GDP-weighted equity indices break the link between country weightings and market size by setting country weightings in proportion to GDP, rather than the aggregate of individual companies’ (and therefore countries’) market capitalisations.
For example, FTSE’s GDP Weighted indices use the IMF’s five-year GDP forecasts, based upon PPP, as the basis for each country’s share within a global or regional index. The FTSE All-World GDP Weighted Index includes developed and emerging segments.
The difference between a GDP-weighted and a capitalisation-weighted approach can be seen in the bar chart below, which shows the top ten country weighting differences between the FTSE All-World GDP Weighted Index and the capitalisation-weighted FTSE All-World Index.
Significant changes result if the GDP-based weightings are applied to the starting set of countries within the FTSE All-World Index. The weightings of the US, UK, Switzerland and Japan fall by 27.58%, 5.17%, 2.86% and 2.68%, respectively, compared with the capitalisation-weighted versions.
The GDP-weighted approach allocates higher weightings to a number of emerging market countries, notably China (+17.83%), India (+7.53%), Russia (+3.00%) and Brazil (+2.20%).
Applying the GDP-weighted methodology only to the developed countries within the FTSE All-World Index (i.e., to the FTSE Developed Index) results in a reduction in weighting for the US, UK, Switzerland and Australia. Germany, Italy, Korea, Japan, Spain and France see their country weightings increase by a switch from a capitalisation-weighted to a GDP-weighted approach.
Stock markets vs. GDP
Differences in country weightings within a capitalisation-weighted equity index reflect differences in the aggregate sizes of individual countries’ equity markets. Such differences reflect several factors: the extent to which a country’s economic activity is represented by publicly listed (as opposed to privately owned) companies, the aggregate earnings of those companies and the valuation attached by the average investor to each unit of earnings.
Other things being equal, in countries where the equity market has traditionally played a significant role in providing a source of finance for economic activity, the ratio of the local market’s capitalisation to GDP is likely to be higher than in a country where local companies have historically relied on other sources of finance: for example, bank loans or retained earnings.
The chart below, which uses data from the World Bank, reveals significant differences in the ratio of individual countries’ equity market capitalisations to the size of their economies, measured via GDP.
Performance of GDP-weighted indexes
In the chart below we show the historical cumulative returns of the FTSE Developed and FTSE Emerging total return indexes, compared to their GDP-weighted equivalents.
Over the period since 16/3/2001, the start of the FTSE GDP Weighted indexes’ history, the FTSE Developed GDP Weighted and Emerging GDP Weighted indexes both performed higher than their capitalisation-weighted counterparts.
The performance of the FTSE Emerging GDP Weighted index (relative to the capitalisation-weighted FTSE Emerging index) was significantly greater than the relative performance of the FTSE Developed GDP Weighted index.
An attribution analysis shows that the primary contributing factor to the outperformance of the FTSE Emerging GDP Weighted Index over the period was the GDP Weighted index’s overweight position in China. To a lesser extent, the GDP Weighted index’s relative overweight position in other emerging markets, such as India and Indonesia, also contributed to its performance.
Uses of GDP-weighted indexes
In the same way as equal-weighted indices, GDP-weighted indexes may be used by those interested in overcoming perceived concentration risks in capitalisation-weighted indices.
GDP-weighting also provides an intuitive link between a global or regional index’s country allocations and the relative economic importance of the countries represented by the index.
However, by contrast with a capitalisation-weighted approach, where countries with larger index weightings have more sizeable and liquid equity markets, in a GDP-weighted index there is no automatic link between country weightings and individual equity markets’ capacity and liquidity. An increased country allocation based on GDP-weighting may also not reflect the access challenges faced by global investors.
For example, on the basis of GDP-weighting, China achieves a much higher weighting in regional and global equity indexes than if market capitalisation is taken into account, whereas China’s domestic equity market is open to non-resident investors only under a restrictive quota system (for further detail, see our FTSE Briefing on China and Global indexes).
Nevertheless, within the overall category of alternatively weighted indexes, GDP-weighted indexes are attracting increased interest from market participants.
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