Allocating to regional equities
Bo Yu
Associate Consultant
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The bottom line:
The US has been the strongest- performing equity region over most long-term periods. Consequently, the average global allocation to equities will have a c.70% weight to the US raising the question as to whether an investor's global equity allocation is truly diversified. Is there a better way to invest?
Should you ever bet against America?
Warren Buffet once said, “never bet against America” and investors who followed his advice would have likely done well. Over most long-term periods, the US equity markets have outshone the majority in terms of local currency returns. This has held true even more so over the last 15 years, where US markets have delivered +531% versus +104% for European and +196% for Asian markets. This has largely been led by the US tech and communications sectors.
But this means the US now comprises 70% of a global market-capitalisation weighted index (MSCI), used as the starting point for many investors’ equity portfolios. The second largest country in the index is Japan with a weighting of just 6%.
Is this weighting toward the US excessive and is a portfolio with 70% in one country, and up to 5% in a single stock truly diversified? We investigate this question and look into the merits of potential alternative approaches.
Why does this matter? Investors have increasingly allocated (through passive means) to global equities in favour of single and often domestic regional allocations. Market indices have also become more concentrated over time (the index compromises a smaller number of large names). The top five names within the MSCI World Index today constitute c. 17% of the index, in emerging markets, it is c. 23%. This means that performance can be more heavily driven by fewer (and often higher correlated) names, leading to higher levels of risk.
So, what are the standard approaches investors take? Could any of the alternative approaches to market cap provide better risk adjusted returns?
The most common (and simplest) approach is a market cap approach. Regional allocations (and the stocks within them) reflect the relative size of their respective markets (and stocks) (i.e. their total market capitalisation). This approach assumes equity markets are broadly efficient, and in theory, reflect the views of the overall market. Far from being a truly 'passive' decision, it is worth remembering it aggregates all the decisions of the thousands of active market participants in order to arrive at the passive weights (as colleague Matt Gibson described in a previous Vista article). Its performance corresponds to the aggregate equity market and is thus typically used as a benchmark for assessing active equity fund performance. Passive market capitalisation portfolios require little rebalancing (mostly in cases where stocks enter or exit an index), and so trading costs are smaller.
Some investors may use a fixed-weight approach, essentially limiting the exposure to certain countries or regions based on their market outlook. Common examples include placing a cap on a certain region (e.g. limiting the US weight of an index at 40%). This could be due to a preference for domestic equities (a home bias), or a desire to avoid a region from a risk perspective (e.g. a lower allocation to emerging markets due to geopolitical concerns). The difficulty with this approach is that making tactical calls and timing them correctly is incredibly difficult. Governance and rebalancing costs also mean fees are typically higher than a market cap-weighted approach.
Finally, a GDP-weighted approach is one that reflects each country’s share in global GDP. It assumes that long-term market returns will be driven by regional differences in economic output (although in reality, this hasn’t materialised). It provides greater diversification as country allocations are less concentrated and offers better risk-adjusted returns. However, GDP weighted approaches are inherently backwards looking and do not take into account growth expectations. Globalisation has also reduced the diversification impact. While a market cap weighted approach appears heavily concentrated in the US, looking at companies’ revenue sources, highlights a more diversified picture than at first glance (less than half the revenue of Apple, Microsoft, and Alphabet were from the Americas over the past year).
Regional weights under different approaches
MCap Weighted
Fixed Weight
GDP Weighted
Source: BlackRock iShares July 2022
Sector weights under different approaches
MCap Weighted
Fixed Weight
GDP Weighted
Source: BlackRock iShares July 2022
Over the long term, the best approach has been market cap due to its relatively large allocation to the outperforming US region. Common decisions over the last decade such as underweighting the US in favour of the UK or emerging markets have not worked for various reasons. For example, investors who had a UK bias would have had both an underweight to infotech stocks and an overweight to value stocks, both of which would have served as significant headwinds. It is important to remember that the market cap approach aggregates all allocation decisions of active managers so the hurdle is already set quite high. While possible, you need to have an extremely good edge (and perhaps luck) to consistently do so.
Investors who thus allocated to equities via a global (passive) approach would likely have outperformed most other broad regional indices or combinations of these. It is worth noting though that markets saw a sharp reversal earlier this year as dollar strength hammered the earnings of the largest index constituents (Apple, Microsoft, Amazon, Tesla), who although domiciled in the US, earn significant revenue in overseas markets, as we noted above.
UK
All Countries World Index (includes EM)
Source: BlackRock iShares
In summary, a market cap approach to global equity exposure has been the best performing, and while it may appear to be particularly concentrated in the US, when broken down further by source of revenues, it actually provides a fairly diversified view.
While these companies happen to be listed in the US, they no longer simply reflect the US economy, and are in fact global in their exposures.
While investors often worry about the dominance of US 'tech', many of the companies you might think of as tech are in fact in the Communications (Facebook, Google and Netflix) or consumer discretionary (Amazon, Shopify) sectors, illustrating the way tech is permeating all aspects of our lives. As the chart shows, more traditional sectors like banks and healthcare have not gone away and remain substantial parts of a market capitalisation portfolio.
Overall, we continue to believe that a global market cap approach provides diversified exposure to a broad range of securities, sectors and sources of revenue that no single market can offer, with an attractive risk/return profile. For investors with strong views, modest divergence from a market approach will likely not be an issue. However, in our view, significantly adjusting regional weightings is unlikely to materially improve the expected risk/return profile of an investor’s portfolios over the long-term.
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