As the World Changes (Or Not)

Story Highlights:

• Indexes can and do change their composition over time.
• That these indexes change is a reminder of the global economy’s fluid nature.
• To truly capture this dynamic, taking a global view of markets is critical.

As the world continues evolving economically, many countries that were largely bit players on the global stage are getting bigger roles. And in many ways, they’re becoming more open to investment—both foreign and domestic. The increasing economic power—along with capital markets modernization--has helped them grow their share of the global marketplace. Tuesday, major index provider MSCI announced its 2011 Annual Market Classification Review—a look at the weighting composition of several of its widely used indexes.

Many people think “Emerging Markets (EM)” are “small countries” and vice-versa, but the designation really says far more about the accessibility and maturity of a foreign market than it does anything size-related. (For example, while relatively huge China and India are Emerging Markets, Luxembourg is developed.) That’s a moving target, and as such, indexes aren’t entirely static—they frequently undergo changes to their composition. Individual stocks move in and out of indexes frequently, as do countries (though less often). Last year, MSCI changed Israel’s categorization from EM to developed. Moreover, these classifications aren’t uniform: Some providers consider South Korea developed, but to MSCI (even after Tuesday’s announcement) it’s an EM. But beyond a reminder about potentially changing index construction, MSCI’s annual announcement actually says a lot about index selection for use as a benchmark.

That the constitution of the world’s equity indexes can change with relative frequency—and views of it differ—is a reminder of the fluid nature of global markets. For investors, this is most particularly pertinent when selecting a benchmark—a critical early step in constructing a portfolio. A benchmark (an index or combination of indexes) is a vital tool serving as both a blueprint for portfolio construction and a measuring stick for long-term performance. It’s also a check and balance to ensure you aren’t skewing too far in the direction of what your gut (all too often motivated by short-term fear or greed) says is right. Choosing a benchmark with return and risk characteristics resulting in a high probability of reaching your long-term goals is critical to investing successfully. Once chosen, it should be a constant guide driven by your goals and needs, changing only when those do.

But with the thousands of indexes available to investors, which to choose? There are country-specific, sector-concentrated and regional—there’s probably one targeting Middle-Eastern Small-Cap Bio-Tech! Commonly, investors tend to focus on their country of origin (US investors focus on the S&P 500, Australian investors on the ASX, etc.). But the world’s economies and capital markets have been interconnected for a long, long time. And they’re not getting any less intertwined now—in many ways, the world is becoming more economically connected and diverse than it’s been. Today, the US represents about a quarter of world GDP and less than half of world market capitalization (to what degree varies depending on the index reviewed). Now, some will view that as sign of a US economic decline, but it’s really more about the global economic pie getting bigger—driven by the growth of all that is non-US.

If your investment focus remains exclusively on US stocks, you might get some incremental globalization benefit through US corporations activities overseas. But you still have many major blindspots. A country’s stock market can move on myriad factors—political, sentiment and economic in nature. Some of those can overlap beyond borders. A US multinational doing a great deal of business abroad, for example, might benefit more or less based on the economic characteristics of countries it’s active in. But just as many don’t overlap—like political drivers, which can have a sizable country-specific impact (for good or ill) that’s mitigated elsewhere. On the flipside, it can also mean stocks in countries with favorable drivers, but where US companies have few interests, could outperform. So to truly capture the dynamic nature of a global economy, a global benchmark is critical.

Being benchmarked globally means you’re positioned across a wide array of countries among which leadership has historically rotated. Since 2000, US stocks’ annual returns have never ranked higher than third out of the MSCI World Index’s 20+ countries (23 until last year, 24 now). And while it might surprise some, that year was 2008. In the 1990s, the US ranked toward the top rather frequently. A global approach means you’re more likely to capture this rotation. It also means, by definition, some constituent country (maybe Norway, maybe Liechtenstein or maybe the US) will outperform a global index as a whole for a week, month or year—while others underperform. But the short-term motivation to seek only the best of the best from a country standpoint obscures the longer-term view. Overlong timeperiods, sufficiently broad and correctly constructed indexes should yield similar results. It’s just that country-specific (or sector-specific) indexes have sharper bursts of outperformance—and sharper busts of underperformance. The broader view that going global takes helps provide opportunities to enhance performance—and also manage risks.

As global capital markets continue evolving, the need for investors to view global markets first and local markets later continues rising. Even if it’s your home country you’re most interested in, that means looking beyond political borders to truly see the forces shaping the world economically.That's one way a global benchmark aids you. To help keep a global focus, put your money where your mind should be.