5. Global Equity Exchange-Traded Funds

The theoretical foundations regarding portfolio diversification and home bias were presented in Chapter 2.

As shown by the results of modern research in the field of social sciences, excess choice can even be harmful to human well-being; it can be a source of unrealistic expectations and even guilt after making a decision. For more on this topic, see, e.g., Schwartz (2004).

There are many factors that contribute to home-country or home-region portfolio bias in global equity investing. The most significant are inertia, return opportunity, and risk control. Others include a preference for familiar, corporate governance, liability hedging, multinational companies, and currency (Scott et al. 2017). Some of these aspects will be discussed later in this chapter.

This analysis covered cases of the worst equity excess return drawdowns (in USD terms) across 17 countries since (in most cases) 1900. The magnitude of losses varied from 51 to 100%, and the length of drawdown periods ranged from two to 17 years.

Although most of the analyses regarding international portfolio diversification referred to in this chapter are carried out from the point of view of an American investor, the benefits of such diversification differ across countries. Driessen and Laeven (2007) found that the merits of investing abroad are largest for investors in developing countries, including when controlling for currency effects. Most of the benefits are obtained from investing outside the region of the home country. Global diversification benefits remain large when controlling for short-sales constraints in developing stock markets. The gains from international portfolio diversification appear to be largest for countries with high country risk. Additionally, diversification advantages vary over time as country risk changes. This will be discussed later in this chapter.

International equity returns, as measured by the MSCI World ex US Index (it captures large- and mid-cap representation across 22 of 23 developed markets (ex-US)), and US equity returns, as measured by the MSCI USA Index (it measures the performance of more than 600 companies representing the large- and mid-cap segment of the US equity market). Interestingly, very similar proportions of American and international shares occur in the most popular global stock indexes (cf. Table 5.3).

Determining an appropriate portfolio allocation, whether for a global allocation or for an allocation within a specific region or country, assumes (in accordance with financial theory) investing proportionally according to market capitalization. This method assumes that markets are reasonably efficient and, thus, stock prices reflect all the available information, investment positions, and expectations of investors.

For example, many flagship pharmaceutical, chemical, and luxury companies are located in Europe, robotic firms in Japan, and technology companies in South Korea and China. What is more, on average, as many as 74% of the 50 top stocks globally (i.e., with the best annual return) in the 2010s were non-US companies.

More on dividends in Chapter 6.

According to Vanguard estimations, the projected ten-year median volatility of global 100% equity portfolio is 15.1% (Davis et al. 2019).

In 2019, economic policy uncertainty (measured by the Economic Policy Uncertainty Index, which provides a real-time measure of policy uncertainty in the economy by incorporating a variety of factors such as tax policy, spending policy, monetary policy, and government shutdowns) was at its highest level since 2011 and the second-highest level in the past three decades (Aliaga-Díaz et al. 2019).

Late stage expansion periods have typically been marked by greater market and economic volatility as well as uncertainty over its persistence. Vanguard estimates a 47% increase in US equity market volatility (measured by the annualized standard deviation of equity returns) when moving from the middle stage of expansion to the late stage, as measured by the CBOE Market Volatility Index (VIX) since 1990 (Wang et al. 2019).

They carried out an empirical investigation of global portfolio diversification in equities and sovereign bonds in the period 1986–2016.

The dispersion of equity returns was measured by their cross-sectional volatility of returns.

The diversification ratio of a set of securities measures the ratio between the weighted sum of the individual security volatilities (using portfolio weights in the sum) and the volatility of the entire portfolio. More about this measure and the theoretical and empirical properties of diversification as a criterion in portfolio construction can be found in Choueifaty and Coignard (2008).

Concentration risk is defined as the risk of a large weight in a portfolio to be exposed to a single source of risk.

The weight of the MSCI USA Index in the MSCI World Index and the weight of the MSCI China Index in the MSCI Emerging Markets Index.

According to most analysts, equity returns over the 2020s are anticipated to be modest at best. Forecasts from Barings (2019) indicate that equity returns in the USA (in local currency terms) will amount 3.2% per annum, while for the UK, Europe, Japan, and emerging markets, it will be 8.0, 6.8, 6.6, and 7.2%, respectively (in the latter—in USD terms). Although global ex-US equities are likely to perform moderately well, these returns are likely to be lower than the high single-digit annual returns that many investors are accustomed and expect in the future. Vanguard presented only slightly better forecasts for the US market and similar forecasts for other equity markets. According to the analysis, the annualized return over the next ten years is likely to be between 3.5 and 5.5%. It pales in comparison with the 10.6% annualized return generated over the last 30 years on the US equity market, and is much lower than expected returns in non-US equity markets, which are likely to be about 6.5–8.5% (from a US investors’ perspective) thanks to relatively more reasonable valuations (Davis et al. 2019).

A high growth economy is defined as an economy that displays above-average GDP growth on a sustainable basis.

Domestic equity portfolios were proxied by their respective MSCI country indexes. Four geographically diversified portfolios (global, developed, emerging markets, and regional) were represented by the MSCI ACWI, MSCI World, MSCI Emerging Markets, and MSCI AC Asia ex Japan/MSCI EM EMEA/MSCI EM Latin America indexes, respectively.

Currency exposure, which affects return volatility, especially in the short-term, can be hedged or removed from international holdings. Primary factors to consider in the equity-hedge decision include currency contribution to volatility, currency correlation with the underlying asset, and investor risk tolerance. Currency-hedging decision is affected by, for example, local market size, currency liquidity in a crisis, hedging costs, and home bias (Roberts et al. 2018).

Global diversification of the equity portfolio also often results in increased risk and costs as a consequence of lower liquidity of some foreign equity markets and higher transaction costs. These issues, in relation to ETF investing, were discussed in detail in the previous chapter.

For example, the 10 largest companies in Europe generate less than a third (30%) of their revenue from their home region (Lovelace and Polak 2019). More on this subject will be presented in Chapter 7.

Documents containing index methodology are generally available free of charge on index providers’ Web sites.

These mistakes can be of a various natures and scales—starting from misinterpreting the name of the index, to misconceptions of its some features (e.g., regarding market capitalization of the index constituents).

This procedure is described using the example of the MSCI Global Investable Markets Indexes (MSCI 2020). In the case of other index providers, it may differ from the one presented here.

These steps refer to each individual financial market. They are usually individual countries, but, e.g., in the MSCI methodology, Developed Markets Europe (15 countries) and West African Economic and Monetary Union (WAEMU) (8 countries) are treated as single markets for the purpose of index construction.

Definitions and properties (e.g., from a tax point of view) of equity-like instruments may vary from country to country or even from one company to another, so index providers often analyze them on a case by case basis.

A detailed description of the procedure in this and subsequent stages of the procedure has been omitted.

Most of the investability requirements are applied at the individual security level, but some at the overall company level, represented by the aggregation of individual securities of the company.

Additional requirements may apply to specific markets (e.g., China).

Composite indexes refer to market capitalization-weighted indexes created by combining individual market indexes.

Creating the size-segment indexes involves the following steps: defining the market coverage target range for each size-segment (e.g., MSCI large-cap indexes cover 70% ± 5% of the free float-adjusted market capitalization MIEU, large- and mid-cap indexes cover 85% ± 5%, and large-, mid-, and small-cap indexes cover 99% ± 1% (0.5)%), determining the global minimum size range for each size-segment, determining the market size-segment cutoffs and associated segment number of companies, assigning companies to the size-segments, and finally applying final size-segment investability requirements.

The lists of countries belonging to developed and emerging markets is determined by a given index provider based on its countries classifications. They will be presented in Chapter 6. As a result, coverage in global equity indexes that cover both developed and emerging markets may vary.

Such restrictive criteria mean that relatively few providers create such indexes; hence, their number and diversity are relatively small compared to regional indexes, for example, as will be described in the following chapter.

Interestingly, at the end of the nineteenth century, the global stock market was more diversified as the three largest countries (the UK, USA, and Germany) accounted for around 53% of world capitalization. The total weight of the 10 largest countries was around 88% (Dimson et al. 2020).

This discrepancy in the case of China has recently been diminished as a result of major index providers starting to introduce more Chinese companies to global equity indexes.

Not all international equity indexes are subject to this drawback. For example, this does not apply to fundamental indexes in which portfolio constituents are weighted by fundamental variables, e.g., book value, cash flow, revenues, sales, dividends, or employment. They can also be an attractive alternative to traditional capitalization-weighted indexes for international investments. The first fundamental indexes were designed and put into practice as far back as the 1990s, but the real growth of interest in the fundamental indexation started in the middle of the first decade of twenty-first century (Miziolek and Zaremba 2017). Equal-weighted global indexes also are devoid of these disadvantages. For instance, the largest weights in MSCI ACWI Equal Weighted Index have Chinese stocks (24.6%), US stocks (20.6%), and Japanese stocks (11.6%).

This does not apply to international equity indexes covering companies exclusively from one selected sector or representing a specific investment theme. Such indexes will be described in Chapter 8.

This characteristic applies, in particular, to broad global equity indexes maintained by MSCI and S&P Dow Jones Indices as they use the Global Industry Classification Standard (GICS). In the case of indexes calculated by providers that use other classifications, the role of individual sectors in these indexes may vary slightly. Definitions and coverage of individual sectors are defined by sector classifications—the most important will be described in Chapter 8.

All data as of the end of 2019.

More on this in Chapter 7.

It is worth adding that country equity indexes (particularly emerging and frontier ones) are sometimes dominated by a handful of industries, and many international sector indexes are dominated by only a few countries. These issues will be discussed in Chapters 7 and 8.

Menchero and Morozov used a global factor model (Barra Global Equity Model (GEM2)) and investigated a large universe of global stocks—all the constituents of the MSCI All Country World Investable Market Index—over the period 1994–2010. Menchero and Nagy applied the Barra Emerging Markets Equity Model (EMM1)—a risk model tailored to emerging markets. In both studies, the MAD measure (i.e., the mean absolute deviation of factor returns) was used to evaluate the relative strength of industries versus countries. MAD is defined as the cap‐weighted average of the absolute value of country or industry factor returns.

In 1900, the share of railway companies in the USA and Great Britain in the total stock market capitalization amounted to approximately 60 and 50%, respectively (Dimson et al. 2020). Even earlier, the US stock market (public companies) was dominated by the financial sector.

In practice, active sector rotation strategies have been used so far in passive investments exclusively in relation to the US market by investing in shares of sector ETFs (e.g., the SPDR SSGA US Sector Rotation ETF, the Anfield US Equity Sector Rotation ETF, and the Main Sector Rotation ETF).

Incidentally, despite the small weights of individual companies, they can sometimes be greater than the weight of a particular country (countries). For example, the weight of the largest company (Apple) in the S&P Global BMI (2.1%) is greater than the individual weights of 41 countries (82% of all countries in the index portfolio) including, e.g., South Korea, Taiwan, India, the Netherlands, or Brazil. The total weight of the two largest firms (Apple and Microsoft) in the main broad global equity indexes presented in Table 5.3 is greater than the individual weights of 47 countries (except USA, Japan, and the UK), including, e.g., France, China, Canada, and Germany. Four US companies (Apple, Microsoft, Alphabet, and Amazon) make up more of the global stock market than any single country apart from the USA.

An exception is, e.g., the Global Dow Index. This is an equally weighted index designed to measure the stock performance of about 150 leading companies from around the world—both from developed and emerging markets. There are only three companies among its top ten constituents that overlap with portfolios of the above-mentioned indexes (as described in factsheet).

One of the few examples of using a different weighing method is the SPDR Global Dow ETF listed on NYSE Arca. This fund seeks to provide investment results that, before fees and expenses, generally correspond to the total return performance of the equally weighted Global Dow Index. This index is made up of 150 constituents, both from developed and emerging countries, which are selected not just on size and reputation, but also on their promise of future growth.

A detailed description of this replication method was presented in Chapter 3.

Some index providers offer also global ex-region indexes (e.g., the MSCI ACWI ex-Europe, the MSCI ACWI ex-Latin America). However, no ETFs tracking these indexes have been created so far.