Transitioning from GDP-weighting: Our new portfolio strategy revealed

• Our managed portfolios have historically followed a GDP-weighted methodology. We have decided to transition away from it, opting instead for a market-cap weighted approach.

• Our pessimistic turn on the long-term prospects of China means we no longer have the same belief and conviction in our GDP-weighted methodology.

• With China's market no longer presenting the opportunities it once did, the US has emerged as a compelling alternative. The best stocks to own in the world are mostly US companies.

• The US has a well-developed capital market, ensuring that it will continue to lead in innovation. The next tech success story is more likely to come from the US, than from Europe or China.

• While drastic changes to any investment portfolios are always discouraged, we believe this is a necessary change. It no longer makes sense to persist with an allocation strategy that is fast losing its relevance and ill-aligned with our long-term views.

For existing clients of our managed portfolio solutions, you may already be familiar with our equity market selection approach within the portfolio, which has historically followed a GDP-weighted methodology, where regional allocations are based on the size of the underlying economies (Chart 1).

While this methodology has served our clients well over the years, seismic changes in the global landscape have prompted us to re-evaluate our strategy. After thorough deliberation, we have decided to transition away from the GDP-weighted approach, opting instead for a more conventional market-cap weighted approach for our managed portfolios.

Why we adopted GDP-weighting from the outset

Before we delve into the motives behind the transition, we’d like to first share the rationale behind our adoption of GDP-weighting from the outset.

Firstly, GDP-weighting reflects our positive long-term outlook on emerging markets.

By design, market-cap weighting skews the portfolio towards countries with well-developed capital markets as the methodology ignores unlisted companies, and shares that are held by insiders and government institutions, since these are not accessible to the investing public. This means that developed countries like the US have large weights in the market cap-weighted MSCI AC World Index relative to the size of their economies, while large emerging markets with less mature capital markets tend to be under-represented.

GDP weighting, on the other hand, captures the aggregated value added by all companies within a country, whether or not they are listed, and is tilted towards countries with large economies but have less mature capital markets. As such, a GDP-weighted portfolio gives investors exposure to the exciting growth prospects from some fast-growing but under-developed emerging markets, such as China and India. The increasing importance of these emerging markets to global growth means that greater consideration must be given to these regions in portfolio construction.

The fundamental idea behind GDP-weighting is that, as these major emerging markets progressively open up and their capital markets mature, their equities will attract inflows that will result in an increase in their overall stock market value. This implies that their stock market size will eventually match the significance of their economies. However, rather than waiting for this eventuality to materialise before investing, we opt to invest now in anticipation of higher returns from these emerging markets in the future.

Secondly, GDP-weighting results in a more diversified portfolio.

Another reason favouring a GDP-weighted approach is diversification. The MSCI AC World Index is dominated by US equities, which currently have a weighting of more than 60% in the index, as high as it has ever been. This has parallels with the way Japan dominated global markets in the 1990s. At its peak, the Japanese market was 44% of the MSCI index. Following the bursting of its stock market bubble, however, its weight in the index fell dramatically to about 10%.

While we are not predicting that the US will follow the same path as Japan, a market-cap weighted approach would have yielded a portfolio that is dominated by US equities. That was not the kind of globally-diversified portfolio that we had in mind when we first launched our managed portfolios. With an allocation that is more evenly distributed across geographical markets, GDP-weighting avoids over-concentration in any single market.

Thirdly, GDP-weighted indices have outperformed their market-cap peers in the past.

At this point, we want to emphasise that our decision to shift from a GDP-weighted approach to a market-cap weighted one is by no means an admission that GDP-weighting has been flawed right from the start. Quite the contrary.

There is evidence that GDP-weighting has produced better returns compared to market-cap weighting in the past. In the two decades through December 2020, the GDP-weighted MSCI ACWI has outperformed its market-cap-weighted peer for the most part (Chart 2), delivering a 6.0% annualised return that rivalled the 5.9% for the market-cap benchmark (in USD terms) despite the latter’s resurgence since 2009.

Chart 2: GDP-weighting has produced better returns than market-cap weighting in the past

Our managed portfolios have also outperformed their benchmarks in the years prior to the massive slump in China’s equity market. The question then beckons: why are we switching away from a GDP-weighted approach now? The short answer is, the approach is no longer relevant. For three reasons.

1. We no longer have a positive view on China’s long-term prospects.

One notable effect of GDP-weighting is that China has the largest and most significant overweight position in our portfolios relative to the MSCI AC World Index (Table 2). This is because China’s share of global GDP is far greater than its market-cap weight in the MSCI AC World Index. Meanwhile, the US is the top underweight position in a GDP-weighted portfolio, as the US has an economic weight that is significantly lower than its market-cap weight.

Table 1: Top overweight and underweight positions in a GDP-weighted portfolio

Top Overweights	Weight Difference (GDP – Market Cap)	Top Underweights	Weight Difference (GDP – Market Cap)
China	15.4%	US	-37.4%
Germany	2.0%	Japan	-1.9%
India	1.4%	Switzerland	-1.3%
Brazil	1.4%	Taiwan, China	-1.1%
Italy	1.3%	Canada	-0.7%
Source: World Bank, MSCI, Bloomberg Finance L.P. Data as of 31 March 2024.

In other words, GDP-weighting is essentially a bet that China will outperform the US in the long-run. In the past, this was a bet worth making. Now, not so much.

China’s economic rise has been remarkable: its embrace of a free market economy has led to decades of high economic growth. Not only does it boast the world’s second-largest economy, its booming consumer market – the largest in the world – has generated vast opportunities for global businesses. What’s not to like about China?

Fast forward to today, and the picture looks markedly different.

Under President Xi’s leadership, China has accelerated its shift to a top-down state-controlled economy that demands businesses conform to the aims of the Chinese Communist Party. Its abrupt policy shifts over the years have also dealt irreversible damage to business confidence. Importantly, seismic geopolitical shifts, with rising US-China tensions at the centre of it, has caused countries to reassess their economic dependence on China. As China becomes increasingly isolated from the world, its economy faces stagnation.

Our pessimistic turn on the long-term prospects of China means we no longer have the same belief and conviction in our GDP-weighted methodology, which would have resulted in a significantly overweight position in China for our managed portfolios.

2. The highest quality companies in the world are predominantly US companies.

With China's market no longer presenting the opportunities it once did, the US has emerged as a compelling alternative. The latter offers a fertile ground for investment: the largest and the highest-quality companies today are predominantly based in the US, spanning sectors such as the digital economy and semiconductor industries. These companies are mostly industry leaders with sustainable competitive advantages that will allow them to stay ahead of the competition.

Most of these companies also operate on a global scale, holding dominant positions not only in the US but also in various international markets. While China also has its fair share of large companies, their operations are primarily focused on serving the domestic market.

Big tech companies stand out as prime illustrations of this trend. More than 50% of global digital ad spending now goes through Meta or Alphabet, up from 38% ten years ago. In the realm of search, Google commands a market share of over 90% globally – an unassailable lead it has maintained since at least 2009. More than 60% of the world’s cloud infrastructure is controlled by just three companies – Amazon, Microsoft, and Alphabet. Big tech’s dominance also extends into the global market for operating systems, app stores, and smartphones.

Moreover, these are the companies that will stand to gain significantly from any future technological advancements. This includes the artificial intelligence (AI) revolution, with big tech having the greatest potential to control every layer of the AI value chain, from hardware to software applications, due to their deep pockets and ability to attract top-tier talent. Even the leading independent AI model-makers are all backed by big tech: OpenAI by Microsoft; Anthropic by Google and Amazon; and Mistral by Microsoft (again).

In other words, the best stocks to own in the world are mostly US companies.

3. Well-developed capital markets means the US will continue to lead innovation.

Moreover, the US has far and away the world’s largest, deepest, and most liquid capital markets.

This means that the US has a very well-developed funding landscape that provides efficient channels for financing businesses. Funding for high-growth start-ups is plentiful, with about half of the world’s venture capital going to firms in the US. Companies that opt for a listing in the US also typically enjoy a higher valuation in contrast to listings on other exchanges.

Such is the allure of the US that even foreign companies have increasingly been eschewing their home markets in favour of a US listing. Spotify, the world’s largest music streaming platform with its roots in Sweden, went public in 2018 through a direct listing of its shares on the New York Stock Exchange. Last year, UK semiconductor company Arm Holdings listed on the NASDAQ despite efforts by the government to get the company to agree to a full UK listing, or at least a dual listing.

This hasn’t always been the case.

In the past, London used to be the primary location for stock exchanges. Over the past few decades, however, the US has emerged as the dominant global hub for equities, with its dominance over the rest of the world steadily increasing. Coupled with a strong innovation ecosystem that also includes universities and institutions like Silicon Valley, the US has a long history of translating its scientific research into large, global technology firms. Europe’s lack of a robust funding landscape means it has been falling behind the US on innovation.

This is an important advantage: having a well-developed capital market is important for innovation. It ensures that the next tech success story, including ones that can potentially define the rules of any future technological advancements – is more likely to come from the US, than from Europe or China. 

Market-cap weighting is now a better allocation method

To sum up, our current world view suggests that China is entering a period of structural decline, while the US is expected to maintain its dominance, not only over China but also over the rest of the world. Consequently, we believe that adopting GDP weighting, which would have resulted in our managed portfolios having a significantly overweight position in China, is no longer in the interest of our clients.

The alternative? Market-cap weighting.

The portfolio allocation method that we once eschewed is now back in vogue with us. We now believe that market-cap weighting will produce a portfolio that is best aligned with our long-term market views, one that is substantially invested in the US and light on China.

Our new neutral allocation can be found in the table below (Table 3). It is based on a market-cap weighted approach with some modifications, one of which is the 20% allocation to digital economy stocks, a standalone component we have retained from our previous methodology. This is due to our strong belief that digital technologies are expected to drive massive disruption in the years ahead. The rest of our portfolio is allocated across Europe, Japan, Asia ex-Japan, and emerging markets. Notice also that China has been removed from our neutral allocation.

While our allocation to the US is only about 40%, significantly below the more than 60% weight in the MSCI ACWI, it is compensated by our allocation to the digital economy, which consists primarily of US companies. In totality, our overall portfolio exposure to the US is closer to 60%, in line with the country’s weight in the MSCI global stock benchmark.

Table 2: New equity neutral allocation

Market	Current Allocation	New Allocation
US	23.5%	40.0%
Europe	23.0%	16.0%
Japan	6.0%	9.0%
Asia ex-Japan	25.5%	10.0%
Latin America	6.0%	-
China	6.0%	-
Emerging Markets	-	5.0%
Digital Economy	10.0%	20.0%
Source: iFAST

While some investors may understandably be concerned about the over-concentration in US equities, it is worth pointing out that a company’s headquarters is no indication of its revenue sources. These days, most blue-chip US companies are multinationals that sell their products worldwide, deriving revenues from a wide range of international markets beyond the US. As such, we are in fact more diversified than it appears.

A drastic but necessary change

Make no mistake: shifting from GDP-weighting to market-cap weighting is a big change.

While drastic changes to any investment portfolios are always discouraged, we believe this is a necessary change – one that is in our clients’ interests – as it no longer makes sense to persist with an allocation strategy that is fast losing its relevance and ill-aligned with our long-term views.

As such, we will be doing a phased rebalancing of the managed portfolios in the weeks ahead to implement this change. We thank you for your continued support of our managed portfolios.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report holds a NIL position in the abovementioned securities.