Challenge the Indexes

Carl Delfeld, 05.22.06, 12:00 AM ET

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When I called on global equity fund managers in Tokyo, Hong Kong and Sydney during the 1980s to pitch American small-cap stocks, I was always struck by the leather-covered ledgers they would pull out to jot down notes. No doubt the leather ledgers have been replaced by sleek notebook computers--and the time to meet with small-cap stock pickers is probably also a thing of the past.

Why? The enormous size of some global equity funds would make even a ten-bagger small-cap stock hardly worth the trouble. The big global fund managers need big-cap liquid stocks and have little choice but to take a top-down approach as they attempt to beat their benchmarks. This presents independent investors with a great opportunity to beat the performance of the big global fund managers. How? By ignoring country index weightings largely based on the size of a country's stock market.

Let's look at how a portfolio manager of a large global equity fund might approach his task of beating a benchmark such as the MSCI. All Country World Index or the MSCI Europe, Australasia and Far East (EAFE) index. The All Country World Index weights 49 countries based on the market value of their stock markets. For example, as of Apr. 21 the index weights Japan at 11%, the U.S. at 45.5%, Australia at 2.3%, Indonesia at 0.13%, Singapore at 0.37% and Germany at 3.1%.

The EAFE index contains 21 countries and excludes emerging-market countries. 48% of the holdings are accounted for by two countries: Japan and the U.K. Add in France and Germany and the percentage climbs to over 64%. Meanwhile, the allocation to more dynamic countries such as Ireland and Austria is 0.94% and 0.40%, respectively.

Another method fund managers use in allocating assets is to divide the world into groups such as North America, Europe, Asia and emerging markets and then to weight countries within these categories differently than the benchmark does. For example, in the MSCI Asia Index, Japan's weighting is a surprising 68.6%, India's 3%, Singapore's 2.3%, while Indonesia's is only 0.78%.

To beat these benchmarks, fund managers allocate assets differently, but my experience is that many of the larger funds are "index huggers" that deviate from the weightings only at the margins. Once the country allocation targets are established, fund managers evaluate what companies they should invest in or use passive vehicles such as exchange-traded funds that track a country's stock market index.

You can see that the whole business is oriented towards the largest stock markets. But just because the global asset-management business is wedded to conventional backward-looking benchmarks doesn't mean that you have to be.

If you want your global portfolio to outperform benchmarks in a big way, unshackle yourself from the country weightings. Look to the future and weight countries based on their growth potential, capital flows, prices and pace of market reforms.

It makes little sense to me to have Japan, the U.K., France and Germany account for 64% of your investments in global markets, so sell your MSCI EAFE index fund or ETF and do some independent thinking.

If the goal for your portfolio is long-term appreciation, India, Ireland, eastern Europe or greater China should have larger allocations than the U.K. or France. The country-specific iShare ETFs are a good tool for this since you can buy into Taiwan (ETF), South Africa (EZA) or Malaysia (EWM) with a click of the mouse.

What about the risk of investing in smaller stock markets? It seems to me that investing in a vehicle tracking the MSCI EAFE index with 48% exposure to Japan and the U.K. is riskier than investing 10% of your portfolio in each of ten countries such as Canada, Singapore, Australia, Ireland, Switzerland and Hong Kong. Sure, an ETF won't discriminate against dicey managements in opaque markets. If you include emerging-market countries, expect your returns to be a bit more volatile--but, to paraphrase Warren Buffett in one of his annual reports, I would rather have a lumpy 15% than a flat 12%.

You can build a portfolio on your own or seek out a smaller, independent-thinking adviser. Michael Gibbs-Harris of MGH Asset Management in New Zealand is one of them. He has built a proprietary model that ranks 40 countries based on valuation and fundamental factors. Currently, he has allocations of 15% for Japan, 14% for Germany, just 1% for the U.S. and none for France or the U.K.

So for big gains, ignore the indexes.

Carl Delfeld represented the U.S. on the Asian Development Bank board and heads the global investment advisory firm Chartwell Partners (www.ChartwellAdvisor.com).

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