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Addressing country concentration with a GDP weighted approach

As market participants continue to seek diversification, GDP weighted indexes are attracting increasing interest.  Similar to fundamentally weighted indexes, GDP weighted indexes are designed to address the potential concentration risks presented by traditional cap-weighted indexes. However, instead of weighting securities by fundamental size, GDP weighted indexes assign country weights by proportionate share of GDP.    

GDP weighted indexes may be particularly useful when a country’s equity market value outpaces its economic output. A dramatic example of this divergence is evident in the late 1980’s Japanese equity markets. According to the International Monetary Fund (IMF), in 1989 Japan’s share of world economic output using PPP was 10%, while its collective share of the FTSE All-World Index that year was over 40%.

GDP weighted indexes are designed to break the link between country weightings and market size by setting country weightings in proportion to GDP. The FTSE GDP Weighted Index Series uses five-year GDP forecasts based on purchasing power parity (PPP) as the basis for each country’s percentage share within a segment.

Weighting by GDP can produce drastically different country allocations relative to traditional cap weighted structures. The ratio of market cap to GDP is often higher in developed nations versus emerging markets, resulting in lower weightings when adjusting for GDP. The United States weighting, for example, drops by over 27% in the FTSE All-World GDP Weighted Index versus the cap-weighted FTSE All-World Index.

 Conversely, weighting by GDP can result in higher allocations to emerging market countries.  China and India allocations are significantly higher for the FTSE All-World GDP Weighted Index when compared to the cap-weighted counterpart.

 Top Ten Country Weighting Differences: FTSE All-World GDP Weighted vs. FTSE All-World

 Source: FTSE, Data as of June 30 2014

This shift in weighting away from more developed countries and toward emerging market countries has been a contributor to stronger relative performance of GDP weighted indexes. Since the inception of the FTSE GDP Weighted Index Series in 2001, the FTSE Developed GDP Weighted and Emerging GDP Weighted indexes both performed more strongly that their cap-weighted equivalents.

 FTSE Developed, FTSE Emerging Indexes vs. GDP-weighted Equivalents: Total Return

 Source: FTSE, March 16, 2001=100. Past performance is no guarantee of future results.   Some returns shown reflect hypothetical historical performance. The performance history of the GDP-weighted indices prior to their launch date (September17, 2013) is based on a retroactive application of the index rules.

 

 

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