Sometimes it’s difficult to remember which countries are in which MSCI regional index.  To the extent that you don’t want to create unintended overlaps of country holdings in your portfolio, this reference table can help.  It lists each country and each of the regional indices in which it is included:

     click image to enlarge

Some of the key funds that correspond to the labeled columns are:

• World: VFWIX + VTSMX  or VFWIX + IWM
• Developed Intl: VDMIX + EWC or EFA + EWC
• Emerging Intl: VEIEX or VWO or EEM
• Latin America: ILF
• Far East ex. Japan: n/a
• EAFE: VDMIX or EFA
• EMU: EZU
• Europe: VEURX
• AsiaPacific: VPACX or VPL
• Asia Pacific ex. Japan: EPP

Richard Shaw
QVM Group LLC 

Disclosure:  Author owns some of the funds listed.

Is comparing countries in terms of GDP growth helpful?

It seems logical on the surface that a country’s GDP growth rate would have a lot to do with sales and profits growth and therefore stock market returns.  It seems that financial journalists and economists think it is important, because they make such a big deal about it in stock market related news.  But, where is the evidence that it matters.  We aren’t sure where it is.

In the short term, we are pretty sure it doesn’t matter.  In the long-term, the idea of a linkage still appeals to logic, with the caveat that individual companies in each country may grow their sales and profits at much different rates than the national economy for any number of reasons.

We took a look at 2006 GDP growth rates for 30 countries with related country investment funds relative to their 1-yr, 3-yr and 10-yr trailing total returns.  We didn’t see anything that suggested a linkage between GDP growth rates and stock market returns.  The chart below shows the data.

      click image to enlarge

Note that for Russia, India and China we used TRF, IIF and CHN respectively to fill in missing 3 and 10 year data points.  For the Russell 3000, we estimated a synthetic ETF 10-year return by subtracting the IWV 20 basis point expense ratio from the Russell 3000 index 10-year return.

What we do see is a simple equal weight average 2006 GDP growth rate of 4.5% (compared to a world average of 5.3%) and a 12-month stock market simple equal weight average total return of 38.4% — no obvious logical relationship there.  The 36-month return of 32.0% didn’t seem logically connected either.  The 10-year 9.7% return was more in the same ball park.

Thinking we might have missed some important correlation, we also made a scatter diagram of the 2006 GDP growth rate versus the 3-year trailing total return.  That was no help.  The chart below shows no clear relationship.

      click image to enlarge

With all the talk about China and India growing GDP faster than the rest of the world, we would have expected to see a more clear relationship between GDP growth rates and returns, but we didn’t see that.  For example, Brazil is growing GDP at only 3.7% compared to 9.2% and 10.0% for India and China, yet Brazil exhibited substantially higher returns than India and a similar  12-month but higher than 36-month return than China.  

The data tend to suggest that either GDP is essentially irrelevant to stock market returns, that the data show the rich getting richer and the poor getting poorer, or that markets are out of equilibrium with fundamental economics (unrealistic expectations). 

Another possibility is that it is better to think of a country fund less as a fund about the country and more a fund about the leading companies in the country.  In the case of the U.S., an argument could be made that the overall stock market does represent the country economy as a whole, but in smaller markets the concentration of assets in a small number of companies makes that concept a bit of a stretch.

For example, the U.S. broad market as represented by IWV (tracking the Russell 3000) has 2,970 stocks in the portfolio, the top 5 holdings account for only 10% of the fund, and are well diversified (Exxon, GE, AT&T, Citicorp, and Microsoft).  On the other hand a fund such as RSX (Russia) has only 30 stocks, the top 5 stocks represent 40% of the portfolio, and are not well diversified (four of the top five are oil energy companies).  See chart below for other examples:

     click image to enlarge

The original question was whether GDP growth has much utility in making country allocations or country fund performance analysis.  That answer appears to be NO.

We recognize that the purpose and character of business and corporations is to accumulate wealth by their operation, but we don’t understand how the differential between global GDP and global stock markets could be so great as a 7:1 world market returns to world GDP growth rate, unless the country funds are not a reflection of the countries themselves.

It’s easy to understand how money and wealth can shift from one corner of the world to the other, but it’s hard to understand how the value of all markets can grow so much faster than all economies. 

We understand the scarcity and demand premium on energy and materials that emerging economies are creating, but we don’t understand how that translates into so many countries doing so well on a total stock market basis.  We also understand that the largest and most successful companies in any country can outperform the country of their domicile, but comprehensive global outperformance doesn’t feel right to us.

In the same way that house prices cannot perpetually grow faster than wages, isn’t it reasonable to assume that world stock markets cannot perpetually grow faster than world economies? 

We’re feeling a little cautious, but also don’t want to run and hide either.  Our antennae are up, because the returns seem too good to be true, and that is often a bad sign.

Richard Shaw
QVM Group LLC

Disclosure:  author owns several country funds listed in this article.

We were asked how a U.S domiciled investor can cover the world on a country basis with no-load, low expense ratio, index funds without creating gaps or unintended overlapping country holdings.  That is probably something a lot of people would like to know.  This article provides the options.

We added the requirement that the index funds be open to retail investors and not require more than $100,000 initial purchase. 

DEMOGRAPHIC BACKGROUND:

The CIA Factbook identifies 237 nations on earth.  MSCI identifies 48 of them as “investable” through public stock markets.  We’ll leave the definition of “investable” for another time.  

Within the range of China (#1 in the world by population) and Ireland, the smallest investable country in the world (#127 by population), there are 48 investable and 79 non-investable countries.  

Smaller than Ireland, there are another 200 countries that are non-investable, ending with the Pitcairn Islands, population less than 50. 

INDEX BACKGROUND:

We have selected MSCI indices for this excercise.  MSCI is arguably the world’s leading international index provider.  These are the 48 MSCI all-world countries:

Argentina, Australia, Austria, Belgium, Brazil, Canada, Chile, China, Colombia, Czech Republic, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong, Hungary, India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Korea, Malaysia, Mexico, Morocco, Netherlands, New Zealand, Norway, Pakistan, Peru, Philippines, Poland, Portugal, Russia, Singapore Free, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, the United Kingdom, and the United States.

The MSCI method is to market weight the countries based on “free-float”.  That means, for example, that China which has a very large total stock market capitalization, has only a small weighting in the index, because most of the shares are not in the free-float.  

Free-float represents those shares of a public company that are readily available for trading at any time.  It excludes closely held shares, restricted shares and government held shares, for example.

There is, of course, the question of allocation weights, but that is the subject of another article. 

INDEX FUND COMBINATIONS: 

One Fund: 

• No solution 

We are not aware of any no-load, low expense ratio, passive index fund that invests in all 48 MSCI investable countries.
 
Two Funds:

• FTSE All-World ex U.S. [VFWIX or VEU]
• Total U.S. [VTSMX or IWV]

The FTSE All World ex U.S. index is substantially the same as the MSCI All Country ex U.S. index with these differences:  FTSE includes Luxembourg, but MSCI does not.  MSCI includes Jordan, Morocco and Pakistan, but FTSE appears not to include them.  It doesn’t really matter, because none of the emerging market funds invest in Jordan, Morocco or Pakistan.  Those three countries may be investable in the eyes of MSCI, but apparently not in the eyes of the emerging market funds. Missing those countries would not be of concern to most investors.

Three Funds:

• Total US
• Total International (ex Canada) [VGTSX]
• Canada [EWC] 

Four Funds:

• Total U.S.
• Canada
• EAFE (Developed Europe, Australasia, Far East) [EFA or VDMIX]
• Emerging Markets [EEM or VWO or VEIEX]

Five Funds:

• Total U.S.
• Canada
• Europe Developed [VEURX or VGK]
• Asia Pacific Developed [VPACX or VPL]
• Emerging

Six Funds:

• Total U.S.
• Canada
• Europe Developed
• Asia Pacific Developed ex Japan [EPP]
• Japan [EWJ]
• Emerging

The reason one might wish to break out Japan from EAFE and Asia Pacific is the very high weightings it has in those indices (75.6% of Asia Pacific and 23% of EAFE).  Breaking out Japan allows for different weighting (up or down) and for a more granular rebalancing effort, if desired.

Seven Funds: 

• No solution 

Eight Funds:

• Total U.S.
• Canada
• European Monetary Union [EZU]
• United Kingdom [EWU]
• Switzerland [EWL]
• Sweden [EWD]
• Asia Pacific Developed
• Emerging

This eight fund solution designed to separate the United Kingdom from the rest of Europe, requires several extra funds.  The European Monetary Union does not include the UK, Switzerland, Sweden and Denmark, all of which are in the Europe index.  This is an imperfect solution because there is no Denmark solution, but because Denmark is only 1.2% of the Europe index and because the UK is a full 33% of the Europe index, it may be worth the hole created by Denmark in order to manage the UK separately.

Nine Funds:

• Total U.S.
• Canada
• European Monetary Union
• United Kingdom
• Switzerland
• Sweden
• Asia Pacific Developed ex Japan
• Japan
• Emerging

There is no current way to break up emerging markets or developed markets more finely and still get full coverage of all 48 countries without creating overlaps.

If full but non-overlapping coverage of the investable country indices through passive management and low cost is your goal, these are your effective options.

Richard Shaw
QVM Group LLC

Disclosure:  Author owns some of the index funds identified.