Coins in Stacks

Q&A with IFA: Cap Weighting or GDP Weighting

Coins in Stacks

Question: What is the merit, if any, in using a country weighting scheme based on Gross Domestic Product (GDP) rather than market capitalization?

Note: The question above was taken from DFA’s Fama/French Forum. Professors Fama and French gave this brief response:

“There are none that we can see. Investors as a whole can't follow this strategy since the aggregate of investor portfolios must be the cap-weighted market portfolio.”

To review, GDP represents the total value of all goods and services produced within the borders of a country, and market capitalization represents the value assigned to publicly traded companies by the market. The notion that there would be a benefit from weighting country exposure by GDP is similar to the idea behind fundamental indexing that individual companies should be weighted on characteristics like sales and earnings rather than market capitalization. The basic idea is that since GDP is a superior measure of a country’s footprint on the global economy rather than the market value of its publicly-traded companies, investors would be better served by having more exposure to higher-GDP countries. Fama and French do not find any merit in this idea, and here is an additional explanation, aside from the impossibility of all investors following this strategy.

For many countries, the availability of public shares is very different from what would be suggested by the GDP. For example, in China, many companies are still owned in part (or in whole) by the government, and in Germany, privately held companies play a larger role in the economy compared to other Western countries. In Mexico, the largest industry (oil) is dominated by a single national company (Pemex). We could go on, but you get the idea—weighing by GDP would result in a distorted global portfolio. The single biggest distortion would come from Italy which comprises only 1% of the global market capitalization yet makes up about 3.5% of GDP.1

On a related note, certain pundits have recently stated that the U.S. stock market is “overvalued” based on the higher-than-historical-average ratio of market capitalization to GDP, which has come to be known as “the Buffett indicator” based on a 2001 interview with Fortune magazine where he said, "It is probably the best single measure of where valuations stand at any given moment."2

Regardless of the source, IFA has always cautioned against using macroeconomic indicators as a basis for asset allocation or market-timing (heaven forbid!). We certainly do not see Buffett himself running to sell his equity positions. In 2012, Vanguard published a study of the predictive value of various commonly-cited macroeconomic factors, which we summarized in this article. Interestingly, more than half of them had less predictive value than the prior year’s rainfall.

Returning to the original question, while it may be sensible to put a ceiling on the exposure to any one country in order to prevent suffering undue harm from a situation like Japan in 1989, weighing countries by GDP instead of market capitalization cannot legitimately be expected to produce higher returns.

1 and accessed on 6/4/2014