Wellian Weekly 26.10.2020

Looking Deeper into The World Index Part 3

In previous notes we discussed a global equity index with Part 1 showing how the top 10 stocks had changed – both in terms of their numbers, but also their weights. Part 2 discussed how the industries and sector weights altered, as well as how the index underwent a major change a couple of years ago.

This piece looks a bit deeper to the country allocations and how they have changed over the last couple of years. This part, as well as the previous two, have been written to alert the reader to a number of risks. The three-part series is not to promote active management or passive management; it is an education piece. If portfolios are constructed using investment managers that adopt an active or passive approach, the least you can do – as a fund selector – is know what has been bought.

One of the key selling points that active managers use is that they have the ability to change the shape of the portfolio. This document (and the other two) have shown that an index can, and does change. Just look at the differing fortunes of Apple and JP Morgan Chase for instance, or the allocation to Healthcare or Information Technology as previously explained. But, the other two pieces in this series have shown that you need to do due diligence on the index because the index can, and does change. One of my biggest bugbears with index investing is that it is rapidly becoming a product in its own right, and not remembered as a composite of the underlying stocks. Indices are NOT passive. The investment style is. They are driven by rules and regularly re-balanced.

Because indices change, the characteristics of the index can change too. Yields might rise or fall, volatilities can alter, weightings of stock, sector, country, duration, credit quality, currency bias, market capitalisation and so on can change and without keeping tabs on these changes, then risks change too.

Part 3 will look at country allocations of the Word Index and in keeping with the other two articles will throw out some questions relating to risk.

As previously mentioned, there are over 1,600 shares of companies that make up the index, and this research really only touches the surface – the focus – when looking at the stocks themselves that create the index - focused on the largest 10. When it comes to country allocation, the focus will be on the largest allocations, even though the index looks at 23 different countries.

There are a couple of rules behind the index:

  • It only invests in developed countries (i.e. it doesn’t invest in emerging markets)
  • The index covers 85% of the listed equities in each country

    The largest countries typically account for c95% of the index and this is typically dispersed over 10 countries, meaning the smallest 13 – combined - account for 5% of the index.

    The index is weighted by market capitalisation of the stock, so the allocation to sectors, and countries, by default, therefore becomes a bi-product. As is fairly obvious, not all stock markets are the same – they have different numbers of stocks, different weights to different sectors, different tax regimes, different political leanings and terms. They have different profit numbers, balance sheet strengths and so on.

    Although the rule suggests the index is composed using the largest 85% of stocks in the index, this too can bring with it bias and these need to be understood.

    It probably wouldn’t be a surprise to say that the US is the largest component of the World Index. In previous papers we have discussed the largest holdings, with US names peppering the list – Apple, Facebook, Amazon, JP Morgan, Microsoft, Exxon and so on consistently appearing. It makes sense that if you are one of the largest stocks in the index and you are registered in the US, then the US is likely to be the largest component of the index.

    But did you know that as at the end of August 2020, the US accounted for 66.36% of the index? That is almost 2/3! This is a risk that you need to be aware of. By having 2/3 of the portfolio aligned to one tax structure, one currency, one political system etc there are a lot of risks that need to be considered.  For instance, in November there is a Presidential Election, and should Joe Biden get to the White House, there could be ramifications for both “big tech” and healthcare stocks. The resultant share prices of Apple, Facebook, Amazon, Microsoft could come under some pressure.  If their share prices fall, their weight in the index would fall and the allocation to the US would fall too. Does it make sense to buy an index that is so heavily weighted to one stock?

    Back in Q4 2014, the US accounted for 56.63% of the World Index, and today’s allocation is the largest weight in the last 71-month end data points used in this document.

    The second largest country in the index is Japan with a 7.48% allocation. The UK is third at 4.06%. The weight to the US is considerable and needs to be considered if the index is being bought from an investment perspective. Back in Q4 2014, the UK allocation to the index was significantly higher at 6.99% although Japan has only dropped a little from 7.79%.  During the last 71 months, the exposure to Japan has been as high as 9.06% and as low as 7.45% (end of July 2020).

    The UK has varied between 7.99% and 4.06%. Therefore, the third largest country in the World Index – the UK – is at the lowest weight it has been over the last 6 years.

    The UK has a low weighting in the World Index – with political uncertainty, a weak currency, a lack of direction regarding Brexit and a stock market that has a high allocation to energy stocks and financials (the oil price hasn’t exactly been stellar for a number of years and with interest rates at all-time lows not really helping profits, it’s probably easy to understand why).

    But, with an allocation of 4.06%, the UK – AS A COUNTRY – has a smaller exposure than Apple! Apple has an allocation greater than the contribution of Australia, Hong Kong and the Netherlands COMBINED. Just consider the different risks - owning 85% of the listed shares of Hong Kong, the Netherlands and Australia (and having lots left over) or owning the entire share capital of one company?

    There are lots of risks out there. In fact, we believe risk management should be renamed risks management. This piece, and the two that precede it hopefully have made some of these risks a bit more obvious and alert the reader to do fundamental research and due diligence.


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