Improving Emerging Market Equity Performance through Equal-Weight Country Indexing

Abstract

Capitalization-weight orthodoxy now dominates in the equity indexing world despite the fact that research indicates it is inefficient and underperforms valuation-indifferent approaches. However, a more important issue for multinational indices—especially in the case of emerging markets—is the method used to determine country weights. Pure cap-weighting allows country exposures to indiscriminately fall out of the bottom-up aggregation process, which significantly over-concentrates risk in only a few countries. This study demonstrates that employing an equal country weighting scheme for emerging markets would have hugely outperformed cap-weighting for the past quarter century. Equal weighting reduces risk by increasing diversification across divergent macro policy regimes and is mean–variance optimal in a special case. In contrast, cap-weighting forces investors into riskier exposure to overvalued markets and is mean–variance inefficient. Unfortunately, there are no equal-weighted broad emerging market indices or commercial products available. Using emerging market country ETFs offers a partial solution, although the full range of emerging markets is not covered and liquidity is sometimes limited.

TOPICS: Emerging, exchange-traded funds and applications, mutual fund performance