Thoughts on Malkiel saying a world index maybe underweight countries like China?

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trago12
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Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by trago12 » Thu Dec 07, 2017 9:19 am

Most indices to my knowledge are based on free float market capitalisation. Malkiel argues that this means China and other countries like it might be underweight, (arguing this on must recent version of Random Walk Down Wall St., and also in the google talk he gave : time stamped https://youtu.be/wnCxlIQjT-s?t=58m )

For instance, in Vanguard Total World Stock ETF China represents 2.6%, whereas its GDP as a percentage of world GDP is around 15%. So Malkiel suggest bulking up more on a country like China.

What are people's thoughts on this?


My gut instinct is that he is right, partly because if you think about macroeconomic risks you are exposing yourself disproportionately to the US vs China, and leaving some diversification on the table.

cheers :happy

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by Lou354 » Thu Dec 07, 2017 10:15 am

It's consistent with his long-standing recommendation to overweight REITs relative to their percentage of overall market capitalization.

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by livesoft » Thu Dec 07, 2017 10:17 am

Malkiel seems to have make huge investments in China and needs people to like China in order for him and his clients make more money. But yes, the world index may underweight stocks from China.

Just remember that investing in the GDP of China is not fully available to investors whether they are Chinese or non-Chinese.
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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by nisiprius » Thu Dec 07, 2017 10:40 am

The theory behind index investing is based on many assumptions, most unrealistic but possibly accurate enough to be useful. The theory concerns the special properties of "the market portfolio," which consists of the total set of assets actually held in a market, whatever a market is. I don't know the economists' definition. However, the theory assumes rational actors who can trade freely and frictionlessly. Under these assumptions, the market portfolio is an optimum with regard to mean-variance. Mean-variance is a proxy, perhaps a poor one, for risk-reward.

The market itself is cap-weighted. The stock market has put 3% (or whatever the current number is) of its money into Apple. If you wish to invest in accordance with the theory behind index investing, and obtain the same results as the market portfolio, you should do likewise.

When someone says confidently that your cap-weighted portfolio doesn't match the weights of assets in the economy, it sounds as if he is saying that it should. I don't want to spend an hour listening to a talk, but if someone has a pointer to a transcript I'd like to glance at it. Often, when this argument is made, the presenter never actually gives a reason why you should weight by economic contribution instead of by market-cap. It is treated as if it were some given, some general consensus. I don't think there is.

If we want our investments to mirror the market portfolio and have the textbook characteristics of the market portfolio, then the world index weights "countries like China" appropriately. If we think that a world index underweights countries like China, then our standard for overweighingt and underweighting is not the market portfolio.
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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by TD2626 » Thu Dec 07, 2017 10:57 am

I think that you could argue that using float-adjusted indices is:

1. Good, because it underweights illiquid companies or those that have a large percentage of their stock controlled by founders, national governments, etc.

2. Bad, because it moves the indices away from the global portfolio - which would in my opinion, in theory, include all assets at cap weight (including private equity) and would (at least according to this article) https://www.forbes.com/sites/phildemuth ... 4d5c3e70d1

I think that using float adjustment may be beneficial because it can punish companies that don't have liquid enough markets or don't make enough of their shares available. However, float adjustment moving the portfolio away from the theoretical mean-variance optimal global portfolio is unsettling.

Oh... maybe the difference is minimal. At least in the S&P 500, float adjustment seems to have had relatively little effect: http://www.indexologyblog.com/2013/07/3 ... djustment/

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by KlangFool » Thu Dec 07, 2017 11:05 am

trago12 wrote:
Thu Dec 07, 2017 9:19 am
Most indices to my knowledge are based on free float market capitalisation. Malkiel argues that this means China and other countries like it might be underweight, (arguing this on must recent version of Random Walk Down Wall St., and also in the google talk he gave : time stamped https://youtu.be/wnCxlIQjT-s?t=58m )

For instance, in Vanguard Total World Stock ETF China represents 2.6%, whereas its GDP as a percentage of world GDP is around 15%. So Malkiel suggest bulking up more on a country like China.

What are people's thoughts on this?


My gut instinct is that he is right, partly because if you think about macroeconomic risks you are exposing yourself disproportionately to the US vs China, and leaving some diversification on the table.

cheers :happy
trago12,

<< For instance, in Vanguard Total World Stock ETF China represents 2.6%, whereas its GDP as a percentage of world GDP is around 15%. So Malkiel suggest bulking up more on a country like China. >>

The problem is even if a person chose to do that, the person still will not get anywhere close to mirroring the GDP of China. So, why bother? This is the problem with many countries where the large part of the economy is concentrated into the State-owned or privately owned enterprise.

KlangFool

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by alex_686 » Thu Dec 07, 2017 11:15 am

trago12 wrote:
Thu Dec 07, 2017 9:19 am
Most indices to my knowledge are based on free float market capitalisation. Malkiel argues that this means China and other countries like it might be underweight, (arguing this on must recent version of Random Walk Down Wall St., and also in the google talk he gave : time stamped https://youtu.be/wnCxlIQjT-s?t=58m )
Yes, he is correct. It is a bit more complex than that.

You have to do some type of free float adjustment to account for cross holdings. If A owns 45% of B, and B owns 45% of C, and C owns 45% of A, and you don't adjust you will be double or triple counting shares.

TD2626 makes a good point but I want to extend on it a bit. China has 2 issues.

The first is that many of the companies are state sponsored. That is, the government owns a large chunk of enterprise. As TD2626 allude too, if a large chunk of shares are not traded it becomes harder to "reconstructed the index" - that is buy the shares you need. Another issue is that investment theory assumes that investors are rational actors looking to maximize their investments. Th Communist Party is interested in balancing profit with other goals, such as social stability.

The second is that China has capital controls. It is all fine and dandy to say you want to invest, but what happens if there are restrictions on how you can invest or if you can take your profits home?

The conventional answer is to figure out how integrated a market is to the world market and discount accordingly. Most developd markets are fully integrated so they are held at a market weight. China is not so it is underweight. As China has become more integrated the underweight has been diminishing.

If not the conventional answer than what? I don't know of any other option.

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by afan » Thu Dec 07, 2017 11:28 am

To follow on the points made by nisiprius

We presume that the market portfolio reflects consensus pricing of the assets that are in the portfolio. We assume that all assets in the market and therefore the assets in the market with home in any particular country, are efficiently priced. But that assumption rests on the fact that the assets are readily traded in the market. It is not some global, religious, statement that all assets are efficiently priced everywhere. It is a property of open markets.

Assets that are not tradeable on the market are not necessarily priced efficiently. The errors are almost certainly larger and the prices may be biased.

The logic of GDP weighting argues that, absent market distortions, the value of all the tradeable assets in a country would have the same market weight as does that country's GDP compared to global GDP. I don't know of any evidence supporting that assumption.

It would make more sense, not perfect sense, but more than GDP weighting, to look at the total value of all assets in a country and weight one's stock allocation according to that. This has the problem that it assumes that the stocks available on the market are good proxies for the value of all the assets that one cannot trade- small businesses, private farms, etc.

I don't see any reason to assume that the, limited number of, Chinese stocks are a good proxy for all the assets in China that are not available for trading in the market. That assumption might be closer to true for the US, where a larger share of all property is traded in the market. But there are still lots of private assets in the US without obvious proxies in the stock or bond markets.

I have the same problem with the notion of overweighting REITs to capture the performance of non traded real estate. As with the stocks of a country that has lots of limitations on what outsiders can buy, it is not at all obvious that REITs are a good proxy for, say, privately held single family homes.
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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by TD2626 » Thu Dec 07, 2017 11:34 am

alex_686 wrote:
Thu Dec 07, 2017 11:15 am
TD2626 makes a good point but I want to extend on it a bit. China has 2 issues.

The first is that many of the companies are state sponsored. That is, the government owns a large chunk of enterprise. As TD2626 allude too, if a large chunk of shares are not traded it becomes harder to "reconstructed the index" - that is buy the shares you need. Another issue is that investment theory assumes that investors are rational actors looking to maximize their investments. Th Communist Party is interested in balancing profit with other goals, such as social stability.

The second is that China has capital controls. It is all fine and dandy to say you want to invest, but what happens if there are restrictions on how you can invest or if you can take your profits home?

The conventional answer is to figure out how integrated a market is to the world market and discount accordingly. Most developd markets are fully integrated so they are held at a market weight. China is not so it is underweight. As China has become more integrated the underweight has been diminishing.
When a emerging market government (such as in China) owns a large chunk of shares in a company that is otherwise publicly traded, you can reasonably say "well, maybe I don't want to be a minority investor alongside them, because their goals include social stability instead of just profit". Also, some people say "I don't want to invest in a company that the government of ____ has a large stake in, due to concerns over that country's stability, human rights record, capital controls, etc."

(Also, companies, particularly partially state-owned ones, could be nationalized easily in some countries). Note that many EM stocks P/E ratios than US stocks, though. Maybe, the market is compensating for this political risk by allowing "cheaper" purchases. (The political risk, in effect, may be partially compensated leaving EM a more-risk, more-expected-return proposition). Note that 'expected' returns are not guaranteed.

I see the clear reason for float adjustment, but it does seem as though maybe the private equity allocation included in the global market portfolio could be partially pursued through the use of non-float-adjusted indices. Is this reasonable?


.

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by triceratop » Thu Dec 07, 2017 11:42 am

KlangFool wrote:
Thu Dec 07, 2017 11:05 am
trago12 wrote:
Thu Dec 07, 2017 9:19 am
Most indices to my knowledge are based on free float market capitalisation. Malkiel argues that this means China and other countries like it might be underweight, (arguing this on must recent version of Random Walk Down Wall St., and also in the google talk he gave : time stamped https://youtu.be/wnCxlIQjT-s?t=58m )

For instance, in Vanguard Total World Stock ETF China represents 2.6%, whereas its GDP as a percentage of world GDP is around 15%. So Malkiel suggest bulking up more on a country like China.

What are people's thoughts on this?


My gut instinct is that he is right, partly because if you think about macroeconomic risks you are exposing yourself disproportionately to the US vs China, and leaving some diversification on the table.

cheers :happy
trago12,

<< For instance, in Vanguard Total World Stock ETF China represents 2.6%, whereas its GDP as a percentage of world GDP is around 15%. So Malkiel suggest bulking up more on a country like China. >>

The problem is even if a person chose to do that, the person still will not get anywhere close to mirroring the GDP of China. So, why bother? This is the problem with many countries where the large part of the economy is concentrated into the State-owned or privately owned enterprise.

KlangFool
Also the fact that a country's GDP growth doesn't have to have anything to do with its equities returns.
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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by Thesaints » Thu Dec 07, 2017 12:06 pm

Vanguard’s 2018 markets outlook just released agrees with Malkiel: foreign developed markets expected to outperform the US within the next few years and China probably seen as the most problematic economy.

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by alex_686 » Thu Dec 07, 2017 12:17 pm

First, a quick note on China's human rights issues. While that may be a valid reason to underweight China it is a subjective one. As such it does not fit well into investment theory or the reason why most indexes currently underweight China.
TD2626 wrote:
Thu Dec 07, 2017 11:34 am
I see the clear reason for float adjustment, but it does seem as though maybe the private equity allocation included in the global market portfolio could be partially pursued through the use of non-float-adjusted indices. Is this reasonable?
Probably not - but going with non-float adjusted indexes probably generate more issues than you solve. The better option is to go with Factor Investing. However there are lots of subjective factors that go into this, so you are moving away from the land of passive investing to active investing.

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by trago12 » Thu Dec 07, 2017 12:19 pm

afan wrote:
Thu Dec 07, 2017 11:28 am
To follow on the points made by nisiprius

We presume that the market portfolio reflects consensus pricing of the assets that are in the portfolio. We assume that all assets in the market and therefore the assets in the market with home in any particular country, are efficiently priced. But that assumption rests on the fact that the assets are readily traded in the market. It is not some global, religious, statement that all assets are efficiently priced everywhere. It is a property of open markets.

Assets that are not tradeable on the market are not necessarily priced efficiently. The errors are almost certainly larger and the prices may be biased.

The logic of GDP weighting argues that, absent market distortions, the value of all the tradeable assets in a country would have the same market weight as does that country's GDP compared to global GDP. I don't know of any evidence supporting that assumption.

It would make more sense, not perfect sense, but more than GDP weighting, to look at the total value of all assets in a country and weight one's stock allocation according to that. This has the problem that it assumes that the stocks available on the market are good proxies for the value of all the assets that one cannot trade- small businesses, private farms, etc.

I don't see any reason to assume that the, limited number of, Chinese stocks are a good proxy for all the assets in China that are not available for trading in the market. That assumption might be closer to true for the US, where a larger share of all property is traded in the market. But there are still lots of private assets in the US without obvious proxies in the stock or bond markets.

I have the same problem with the notion of overweighting REITs to capture the performance of non traded real estate. As with the stocks of a country that has lots of limitations on what outsiders can buy, it is not at all obvious that REITs are a good proxy for, say, privately held single family homes.
Hey thanks for the post interesting points

When you say that assets that are tradable on the market are not necessarily priced efficiently.
My understanding of it is that whilst large chunks of these companies are owned by the Government ( say 50% government owned?), but are still freely traded on Shenzen and Shanghai markets (for the other 50%) - hence enabling some sort of efficiency..?

Also, I haven't researched properly the ETFs available and how representative they are, but on first glance MSCI seem to offer ability to invest in mainland China stock market, so using this bulking up on China method wouldn't mean just using Hong Kong listed stocks as a proxy.

Sorry if i've misinterpreted you!

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by SimpleGift » Thu Dec 07, 2017 12:23 pm

trago12 wrote:
Thu Dec 07, 2017 9:19 am
For instance, in Vanguard Total World Stock ETF China represents 2.6%, whereas its GDP as a percentage of world GDP is around 15%. So Malkiel suggest bulking up more on a country like China.

What are people's thoughts on this?
It's worth noting that, while China may not yet make up a large percentage of global market capitalization, the Total World Stock Index has a substantial economic exposure (percentage of corporate revenues) derived from China and other emerging markets (chart below).
In other words, the companies in today's global market cap index are already heavily exposed to the Chinese economy — and I'm not sure I'd want more even more China revenue exposure than is already in the index.
Cordially, Todd

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by alex_686 » Thu Dec 07, 2017 12:36 pm

trago12 wrote:
Thu Dec 07, 2017 12:19 pm
When you say that assets that are tradable on the market are not necessarily priced efficiently.
My understanding of it is that whilst large chunks of these companies are owned by the Government ( say 50% government owned?), but are still freely traded on Shenzen and Shanghai markets (for the other 50%) - hence enabling some sort of efficiency..?
Maybe. As a counter example I would point to Facebook. There are not enough shares out there trading in the open market for index funds to hold the non-float adjusted weight. When you get to the 50% level you run into technical issues for index funds get enough shares.

Next point. The level of efficiency should be reflected in the level of integration and thus the correct level of underweighting. It is not a binary on/off thing. It is levels of grey.

During the last stock market crunch China did a couple of things. It banned short sales. It loosened margin requirements. America did this to some extent in 2008 It encouraged / ordered other state sponsored organizations not to buy, not sell. It locked up journalist for reporting that the market was bad. It imposed currency controls.

The free market exerts some control, the Communist Part exerts some control. Figuring out the correct allocation thus becomes a subjective art, not a objective rational decision.

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by trago12 » Thu Dec 07, 2017 12:38 pm

SimpleGift wrote:
Thu Dec 07, 2017 12:23 pm
trago12 wrote:
Thu Dec 07, 2017 9:19 am
For instance, in Vanguard Total World Stock ETF China represents 2.6%, whereas its GDP as a percentage of world GDP is around 15%. So Malkiel suggest bulking up more on a country like China.

What are people's thoughts on this?
It's worth noting that, while China may not yet make up a large percentage of global market capitalization, the Total World Stock Index has a substantial economic exposure (percentage of corporate revenues) derived from China and other emerging markets (chart below).
In other words, the companies in today's global market cap index are already heavily exposed to the Chinese economy — and I'm not sure I'd want more even more China revenue exposure than is already in the index.
Interesting!
Nice angle to consider it on.

However, to push back a little on this, do you think there is a difference in the type of exposure you get through foreign companies vs domestic in terms of the country specific risk?

For instance, lets say China becomes more hostile to foreign Multi Nationals, this hurts your Chinese exposure through using standard world index, but it wouldn't hurt domestic Chinese stocks.
So could there be asymmetric effects to the different types of Chinese exposure?

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by SimpleGift » Thu Dec 07, 2017 12:52 pm

trago12 wrote:
Thu Dec 07, 2017 9:19 am
However, to push back a little on this, do you think there is a difference in the type of exposure you get through foreign companies vs domestic in terms of the country specific risk?
To some degree, I believe you're right. One can't exactly duplicate exposure to local Chinese companies with revenue exposure by foreign companies to the Chinese economy. However, as various quotas and investment limits are relaxed on foreign ownership of Chinese mainland shares in the years ahead, more China A-shares will be showing up in the international indexes:
Looking ahead, if all Chinese stocks were included at their full, free-float, market-cap weighting (mainland and offshore stocks, with no foreign ownership restrictions), they'd comprise about 50% of the emerging market index (chart above), and 13% of the global market cap index (exceeding Japan's current cap-weight), according to FTSE. So cap-weighted index investors should already be expecting progressively higher China allocations in the years to come, in my view.
Cordially, Todd


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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by GAAP » Sat Dec 09, 2017 1:30 pm

nisiprius wrote:
Thu Dec 07, 2017 10:40 am
If we want our investments to mirror the market portfolio and have the textbook characteristics of the market portfolio, then the world index weights "countries like China" appropriately. If we think that a world index underweights countries like China, then our standard for overweighingt and underweighting is not the market portfolio.
And if we truly want our investments to mirror the market portfolio, we would hold a lot more bonds in general -- and international in particular -- than most participants in this forum seem to like. The total world debt market is roughly double the total world equity market and closer to 2.5 times the US equity market...

I do agree that market weighting makes more sense than GDP weighting -- especially since GDP for a developing economy may not be something you can really invest in unless you live there.

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by trago12 » Sun Dec 10, 2017 8:03 am

nisiprius wrote:
Thu Dec 07, 2017 10:40 am
The theory behind index investing is based on many assumptions, most unrealistic but possibly accurate enough to be useful. The theory concerns the special properties of "the market portfolio," which consists of the total set of assets actually held in a market, whatever a market is. I don't know the economists' definition. However, the theory assumes rational actors who can trade freely and frictionlessly. Under these assumptions, the market portfolio is an optimum with regard to mean-variance. Mean-variance is a proxy, perhaps a poor one, for risk-reward.

The market itself is cap-weighted. The stock market has put 3% (or whatever the current number is) of its money into Apple. If you wish to invest in accordance with the theory behind index investing, and obtain the same results as the market portfolio, you should do likewise.

When someone says confidently that your cap-weighted portfolio doesn't match the weights of assets in the economy, it sounds as if he is saying that it should. I don't want to spend an hour listening to a talk, but if someone has a pointer to a transcript I'd like to glance at it. Often, when this argument is made, the presenter never actually gives a reason why you should weight by economic contribution instead of by market-cap. It is treated as if it were some given, some general consensus. I don't think there is.

If we want our investments to mirror the market portfolio and have the textbook characteristics of the market portfolio, then the world index weights "countries like China" appropriately. If we think that a world index underweights countries like China, then our standard for overweighingt and underweighting is not the market portfolio.


So i don't have a transcript for you but, I did time stamp the video, he talks about what i mentioned in my post at around 58 minutes in the QandA section.

And if I understand you properly... Then I think you are kind of in agreement with Malkeil the "problem" with world indices is that they aren't cap-weighted, they are free float cap weighted. So one might want to move to a cap weighted investment, by tilting towards like countries like China.
- I think he was just using GDP as a lazy proxy for an indication of size/importance

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Re: Thoughts on Malkiel saying a world index maybe underweight countries like China?

Post by in_reality » Sun Dec 10, 2017 9:24 am

trago12 wrote:
Sun Dec 10, 2017 8:03 am

And if I understand you properly... Then I think you are kind of in agreement with Malkeil the "problem" with world indices is that they aren't cap-weighted, they are free float cap weighted. So one might want to move to a cap weighted investment, by tilting towards like countries like China.
- I think he was just using GDP as a lazy proxy for an indication of size/importance
I think they should be free float cap weighted.

If the total value total of every stock traded on its exchanges is only a third of its economic output, so everyone triples their Chinese holdings in an attempt to reflect the true size of the Chinese economy (GDP), then ownership in Chinese firms will be much greater than GDP. Non-traded ownership would be 66% of GDP and market cap of trades shares would be 100% of GDP.

If 100% of profit is going to the traded shares, I guess there would be no problem. Is that the case?

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