(Bloomberg Opinion) -- You’re young. You’ve got a little money to put away every month. You aren’t madly engaged with markets. But you want to invest for the long term in a low-cost, properly diversified manner. What do you do? Ask almost anyone and you will get the same answer.
You buy an exchange-traded fund that tracks the MSCI World index. It’s cheap. It’s simple. It’s got a bit of everything in it, and the data regularly show that buying and holding it means you get better returns than from most of the world’s actively managed funds. Add it all up, and it’s hard to see why you’d do anything else.
But look at little harder and you will begin to see a problem. The MSCI World Index might have a little bit of all sorts of things in it (a little France, a little Italy, a little Spain, for example), but it also has an awful lot of just one thing, US equities — and in particular an absolutely massive weighting toward what are now known as the Super Seven or the Magnificent Seven (Apple Inc., Amazon.com Inc., Alphabet Inc., Meta Platforms Inc., Microsoft Corp., Nvidia Corp. and Tesla Inc.) or sometimes the MegaCap-8 (the previous 7 plus Netflix Inc.). There might be 1509 companies represented in the index, but nearly 20% of it is made up of just eight of those companies.
That’s not all. Add in the other US stocks, and an astonishing 70% of this world index is made up of US stocks alone. The next biggest country market in there is Japan with 6.1%. The UK has just under 4%. It is also worth noting it has a relatively unusual definition of “world,” in that not only is it mostly all about the US, but it includes only other developed world markets. If you thought that “world” investing included a little exposure to India, Vietnam or even Singapore, you thought wrong. For that, you’ll be needing the MSCI Emerging Markets Index or the MSCI ACWI (all country world index), although even with that you’ll still be 60% in the US and very heavily in the Super 7 — the market cap of these inside the MCSI ACWI is more than that of Japan, the UK, China and France combined.
This is in large part about momentum. The MSCI World index is market capitalization-weighted, so the bigger any one company’s market cap gets — the more expensive it gets — the more of the index it makes up. And the Super 7 have been getting bigger and bigger. Year to date, they are up an average of 68%. Some are up more than others (Nvidia up 227% but Apple only 56%, for example), but they have all had a fantastic year. The rest of the world is up an average of 10% — the result being that the Super 7 weighting has gone up.
This is obviously not bad news, nor is it necessarily going to become bad news. US companies have a stunning track record of exceptionalism — producing constantly higher return on equity for example than other countries. They also keep showing excellent earnings growth. Ed Yardeni of Yardeni Research points out that even with the surge in their stock prices, “growing optimism about future earnings growth has meant the group’s forward P/E has increased only modestly this year. It stands at 27.9, well above the low of 21.1 at the start of this year but well below the high of 38.5 in August 2020.”
However, it does mean that some people holding these indices are not the kind of investor they think they are. If you want to be a long-term fully diversified global investor rather than a momentum-based US tech investor, perhaps you should not be a MSCI World or ACWI investor.
Instead, you might want to look at a different kind of index — an equal-weighted one. In these, it doesn’t matter what the market capitalization of a company is. Big or small, rising or falling, all companies get equal space in the index. The result is an index that’s weighted more to value (as a stock goes up, some of it has to be sold to rebalance to equal weight, and conversely, as a stock goes down, more of it has to be bought). Take the MSCI World Equal Weighted Index. The top 10 constituents make up just over 1%. The US is 41% not 60%, and Japan is 16% not 6.1%.
That in turn changes the valuation figures. Numbers from Duncan Lamont at Schroders Plc show that if you look at the US stock market on an equal-weighted basis rather than a market cap-weighted basis, relative to the last 15 years it doesn’t look particularly expensive. It’s 2% below its 15-year average in forward P/E and dividend-yield terms and close to even in trailing P/E and price-to-book terms (note that on a market cap basis, it is 13% overvalued on forward P/E terms and 34% overvalued in price-to-book terms).
Go global, and things look even more interesting. On an equal-weighted basis, global stock markets are 7% undervalued relative to the last 15 years in trailing P/E terms, 11% undervalued in forward P/E terms and 9% undervalued in dividend-yield terms.
The message here is pretty clear: If you are an index investor worried about valuations and about market concentration, look for an equal weight index to buy. And maybe do so quickly. Schroders research also shows that there is a “strong, statistically significant, relationship between the degree of concentration in the S&P 500 and how the equal-weighted S&P 500 has performed relative to the S&P 500. The higher the concentration, the greater the outperformance of the equal-weighed S&P over the next five years.” It makes sense that this should hold for the US-heavy global indices as well.
The good news is that you can buy an exchange-traded fund that tracks the MSCI ACWI index as easily as one tied to the MSCI World. Do so and you’ll have what you thought you had in the first place: a well diversified, global, cheap, and simple investment that might last you for life.
(Webb was also formerly a contributing editor at the Financial Times. And she is a non-executive director of two investment funds, Murray Income Trust Plc and Blackrock Throgmorton Trust Plc.)
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To contact the author of this story:
Merryn Somerset Webb at [email protected]
