The Tycoon Report

The Skinny on Trading Global Indices

Thursday, April 16, 2009 | Bob De Dea

Today we're not going to talk about the stains that tobacco spit leaves in baseball dugouts. (Great image, huh?) Nor are we going to talk about the "Bob ♥ Emily" carving in the park bench in Seattle's Golden Gardens park. (If you're a police officer, my real name isn't Bob.)

But we are going to talk about benchmarks. (Didn't see that coming, did you?)

Benchmarks are useful as a measure for portfolio performance (i.e., relative strength), but they are also instructive when putting together a portfolio (e.g. weightings by industry, sector or country). And today, I'm going to give a rundown of the major indices and the characteristics of each and suggest some global indices worth checking out.¹

First things first: Not all indices are cut from the same cloth. Some are price-weighted, some capitalization-weighted. Study this chart and let's sort out the difference.



In a price-weighted index, Company ABC's $50-per-share price has 50 times the impact of the $1 stock XYZ. In a capitalization-weighted index, however, XYZ has 10 times the impact of the $50 ABC stock.

How can this be? Because in a cap-weighted index, the price per share is irrelevant; all that matters is the third column (i.e., market capitalization). Remember, a stock's price is meaningless in and of itself, completely arbitrary.

So it follows that, in a price-weighted index, a 20% rise in ABC's stock price would cause a 19.6% change in the index (0.98 x 20%), whereas in a cap-weighted index it would cause a 1.8% change (0.09 x 20%).

To put it another way, a higher-priced stock's movement in a price-weighted index will necessitate a greater change than the same movement in a cap-weighted index. You can see how cap-weighted indices make better benchmarks because they show how the money flows, not just the price movement of the security.

There are also equal-weighted indices (which I personally use when determining relative strength of a security) and fundamentally weighted indices (where, for example, dividends and earnings-per-share (EPS) are taken into account in the weightings), but these are less common and are therefore less commonly referred to.

Moving right along.

I've listed below a few of the major world indices, their weighting category and the number of stocks in each.

COUNTRY	INDEX	CATEGORY	NO. OF STOCKS
U.S.	Dow Jones Industrials	Price-Weighted	30
U.S.	Standard & Poor	Cap-Weighted	500
Japan	Nikkei	Price-Weighted	225
Japan	Tokyo Stock Price Index (Topix)	Cap-Weighted	1,713
Hong Kong	Hang Seng	Cap-Weighted	45
Germany	Deutscher Aktien Index (DAX)	Cap-Weighted	30
France	Cotation Assistee en Continu (CAC)	Cap-Weighted	40
U.K.	Financial Times (London) Stock Exchange (FTSE) All-Share Index	Cap-Weighted	800
Australia	All Ordinaries Index (AOI)	Cap-Weighted	500
U.S.	Russell 3000	Cap-Weighted	3,000
U.S.	Dow-Jones Wilshire 5000	Cap-Weighted	5,000
U.S.	New York Stock Exchange	Cap-Weighted	1,850
Canada	S&P/TSX 60	Cap-Weighted	60

Now, while an index containing more stocks than others doesn't necessarily translate into it being "better," typically the bigger indices are more diversified and representative of the larger market. That said, an index with 500 constituents could be just as diversified as the one with 3,000.

A Note About the Float

As we saw in the earlier example, market capitalization is calculated by multiplying the share price by the number of shares outstanding. But not all shares are in the market and available to trade, as some shareholders are restricted as to how many and when they can sell shares. (Think company execs.)

A float-adjusted index subtracts these locked-up shares from the outstanding shares to get the "float," and then multiplies the share price by this figure to get the float-adjusted capitalization. Most of the indices above are calculated in this fashion.

But the trouble with the above indices is that they're country-specific. If there's one thing we learned from the recent economic meltdown, it's that, although not all markets are created equal, they inevitably will affect each other in our global economy.

To paraphrase John Donne, "No country is an island." Well, OK -- some countries are islands, but I'm sure you catch my drift, continental or otherwise.

That's the reason I decided to concentrate on global indices today. Diversification is the name of the game and, to be properly diversified, you need to invest outside of the United States.

But, what about investing in American companies that have a large presence abroad? These companies make up a significant portion of the U.S. stock market, since the largest companies at home are the ones that can afford to expand internationally.

The trouble is that American companies overseas act like American companies, not overseas companies. The same is true for overseas companies that do business in America. Different regulatory requirements, different accounting procedures, different managerial methods -- all have a bearing on a company's performance, making them behave like they would at home.

Don't believe me? Take at look at the chart below.



This is a 10-year chart of the Morgan Stanley Multinational Index (NFT). It tracks 50 U.S. stocks that make quite a splash in the overseas pool.

It's charted against the S&P 500 for the same period. Hmmm. Not much difference, is there? In fact, these companies' performance correlates quite well with the performance of the top 500 companies at home.

So much for that myth.

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The Global Indices

All of the indices I'll discuss below are capitalization-weighted and float-adjusted. These are worth considering as benchmarks because, depending on your chosen investment emphasis (more on that in a moment), they each provide a pretty good benchmark.

Morgan Stanley Capital International created the EAFE Index, consisting of countries in Europe, Australasia (New Zealand, Australia and Papua New Guinea), and the Far East. Only developed markets outside of North America comprise this index. The United States and Canada, however, make up a big chunk of the world market, so the MSCI World Index adds North America back into the equation.

But, wait a minute. You might have noticed that these two indices only include developed countries -- aren't the hottest companies to peg for growth coming from emerging markets?

Well, this is why MSCI created the All Country World Index, which fills the gap somewhat by including 23 developed-country market indices and 23 emerging-country market indices. So, if you want to include both in your portfolio, the ACWI would be a good index to model your portfolio on. If, on the other paw, you wanted to play it a bit safer and stick to developed countries, the EAFE or World Index would be better choices.

Another 'World' of Investment Opportunities

FTSE Group is another index provider. The initials stand for Financial Times (London) Stock Exchange, since it's a partnership between the two.

They have products similar to those provided by MSCI. For instance, its Developed All Cap Index contains the same countries as the MSCI World Index, plus Israel. Its Global Equity All Cap Index contains over 8,000 stocks from around the earth.

Let's take a sec to examine the country weightings for the FTSE Developed All Cap Index:


Notice that the United States, the United Kingdom and Japan make up almost 70% of the index. This is typical, though, of the world markets, and you'll find most other developed country indexes will vary by only a few percentage points in their weightings.

For example, the MSCI World Index has the U.S. at about 47%, the U.K. at almost 11%, and Japan at just shy of 10%. Austria and Ireland, on the other hand, are at about half of their MSCI World Index percentages -- but then again, half of 0.3% ain't much!

I wanted to show you this to reassure you that the indices I've picked to talk about are representative of the international economy.

But, as I've said, without emerging markets, we aren't representing a truly global economy. Let's look at the country breakdown for the MSCI ACWI:


I've highlighted the emerging markets above to show how the bulk of the world's wealth is still in developed countries, and they therefore make up the better portion of global indices. In fact, the countries highlighted above account for only 9.84% of the the total index.

Now, let's look at the sector percentages.
Pretty good balance here, eh? And if you compare it to the MSCI World Index, you'll see that it isn't much different, again because the emerging markets' weightings are not enough to change them drastically.

Why, then, should I be concerned about emerging markets? Why not stick to the developed countries? 

Well, because when those emerging markets do turn to the upside, their rise can be meteoric -- fast and considerable. And this will impact your bottom line in a very pleasing way.

In the table below, I've summarized the benchmarks we've discussed (and a couple we haven't) to help in developing your global investment strategy.

INDEX	NO. OF COUNTRIES	NO. OF  STOCKS	COUNTRIES (when available)
MSCI EAFE	21	9832	Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom
MSCI World Index	23	1,6782	Same as above plus Canada and the United States
MSCI All Country World Index (ACWI)	46	2,4152	Same as previous plus Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey
FTSE Developed All Cap Index	24	1,958	Australia, Austria, Belgium/Luxembourg, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United States and the United Kingdom
FTSE Global Equity All-Cap Index	48	8,000	Comparable to MSCI ACWI above
Dow Jones Developed  Markets Total Stock Market  Index	28	10,028	Australia, Austria, Belgium, Canada, Cyprus, Denmark, Finland, France, Germany, Greece, Hong Kong, Iceland, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, South Korea, Spain, Sweden, Switzerland, Taiwan, the U.K. and the U.S.
Dow Jones Global Total Stock Market Index	65	12,119	Same as previous plus Argentina, Bahrain, Brazil, Bulgaria, Chile, China, Colombia, Czech Republic, Egypt, Estonia, Hungary, India, Indonesia, Jordan, Kuwait, Latvia, Lithuania, Malaysia, Malta, Mauritius, Mexico, Morocco, Oman, Pakistan, Peru, Philippines, Qatar, Romania, Russia, Slovakia, Slovenia, South Africa, Sri Lanka, Thailand, Turkey, United Arab Emirates
S&P/Citigroup World Broad Market Index	26		Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the U.K. and the U.S.
S&P/Citigroup Global Broad Market Index	47	11,000	Argentina, Australia, Austria, Belgium, Brazil, Canada, Chile, China, Czech Republic, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Malaysia, Malta, Mexico, Morocco, Netherlands, New Zealand, Norway, Peru, Philippines, Poland, Portugal, Russia, Singapore, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, the U.K. and the U.S.

Next week we'll look at some Exchange-Traded Funds (ETFs) that track indices. In the meantime, take a break and enjoy the spring blossoms!


¹ I am indebted to Aaron Anderson for the inspiration for this article. He gives a fine overview of global investing in his book "Own the World."
² As of April 10, 2009, courtesy of MSCI Barra. All the ACWI charts for this article have been provided by MSCI Barra.





Bob De Dea
Guest Contributor
The Tycoon Report