Going against the herd

A common benchmark for many portfolios is the MSCI World Index, a market capitalisation-weighted index of developed market equities.

A company’s market capitalisation is essentially its size. For example, the world’s biggest company by this  measure is Apple. Its market cap – the number of shares multiplied by the share price – is currently $2.84 trillion.(1)

A market cap-weighted index allocates the most amount to the biggest companies. Apple has the biggest weighting currently, followed by Microsoft.(2)

When funds are benchmarked, and their performance is judged relative to an index, they often stick quite closely to it. They might have a bit more or less in Apple, for example, but they won’t deviate too far in case they get it wrong.

The problem is that relative performance doesn’t pay the bills. If the index falls 30%, but the fund only falls 28%, it has outperformed. However, the portfolio has still lost money, so we wouldn’t call that a successful investment!

Diversification or di-worse-ification?

One of our key investment principles is to be highly diversified – encompassing various asset classes, sectors, regions, and currencies. Many academic studies show that this approach is the most effective way of reducing risk.

However, the MSCI World is far from diversified, with 70% allocated to the USA. Most of these stocks are technology related. Nearly a quarter (23%) of the index is in information technology, whilst 7% is in communication services  (including Alphabet – the parent company of Google, and Meta – the owner of Facebook and Instagram). Amazon is classed as ‘consumer discretionary.’ Therefore, in our view, the true “tech” allocation is closer to 40%.

Whilst the index allocates more to the biggest companies, research tells us that you can typically expect higher returns over the long run from smaller companies.

Smaller companies can easily double in size if they are successful. For Apple to double, it would have to increase its size by another $2.84 trillion.

For context, this is more than the annual economic output of France ($2.78 trillion in 2022).(3)

Emerging market equities aren’t included in this index, and again, these have been shown to outperform over time. Since 1987, the MSCI Emerging Market Index has returned 923.74%, whilst the MSCI World was up 676%.(4)

Of course, in the short term, things can be very different. Recently, big US tech stocks have performed phenomenally well due to excitement about artificial intelligence.

But the MSCI World Index hasn’t always been so US-centric. Back in 1987, the biggest weighting was to Japan, accounting for 40% of the index, with only 32% in US stocks.(5)

However, over the last 36 years (31/12/87 to 31/12/23), the MSCI Japan Index is up just 16%!

Currently, Japan represents only 6% of the MSCI World Index.

Investing heavily in the winners of the past can be a dangerous game, and that is what you are doing by buying a market cap weighted index.

Credit where credit’s due

In the bond or credit markets, index providers again allocate based on size, with the most amount of money allocated to the biggest bond issues.

This ensures the indices remain relatively liquid with the biggest bond issues generally the most easily tradable. This is important as most bond trades don’t take place on an exchange like equities, but rather are carried out “over the counter” where trading costs can be significantly higher.

But allocating money in this way has another problem. When you buy a corporate bond you are lending money to a company, and this comes with credit risk. If the company goes bust you can lose some or all of your investment.

By allocating the most to the biggest bond issues, what the index providers are essentially doing is putting more money with the companies with the most debt! That doesn’t seem like a sensible strategy in our view.

In both bonds and equities, we do use index tracking funds on a selected basis. We tend not to use them for corporate bonds for the above reasons, but we do use them for government bonds where we are less concerned about credit risk.

Index tracking funds can be a cheap and effective way of gaining access to a broad asset class when used sensibly.

In equities, we would advocate tilting exposure a little bit towards smaller companies and diversifying globally, which has been shown to aid returns over time. This can be done via actively managed funds, but we also do this by using index funds.

For example, in US equities we hold two “alternative” index funds alongside our S&P 500 tracker. One tracks a small cap index of stocks outside the top 500.

The other invests in the top 500 but does so in a different way. Rather than putting the most into the largest companies, this fund puts an equal amount in each stock.

Again, over the long term this has been shown to outperform. From 31/12/1998 (the earliest we can take this back) to 31/12/2023 the equal weight version of the S&P 500 index has returned 1,005.21% compared to the cap-weighted at 601.1%.

We spend a lot of time making sure we keep the cost of investing as low as possible. Using index trackers sensibly is an important part of that, but also important is negotiating with active managers where we use them. By doing so, we can often achieve significant discounts on the headline costs.

This article is intended as an informative piece and should not be construed as advice. Past performance is for illustrative purposes only and cannot be guaranteed to apply in the future.

Sources

(1) LSEG Datastream 15/02/24

(2) MSCI

(3) Trading Economics

(4) LSEG Datastream 31/12/87 to 31/12/23

(5) Researchgate