Two GDP-Weighted ETFs Proposed; A Better Mousetrap?

by on August 30, 2010 | ETFs Mentioned:

With growth levels in the U.S. stagnating thanks to high unemployment levels and minimal policy options due to massive debt burdens, many investors have looked beyond American shores in order to find investment allocations that can potentially offer more growth and greater returns. While there is no shortage of international and emerging market ETFs on the market today, some investors have expressed frustration with the “exposure biases” built into the largest and most liquid options available. That is particularly the case with many of the diversified global equity ETFs  available; many of these funds concentrate holdings into a small handful of countries using weighting strategies that don’t correspond to true economic size [see How Global Is Your Global ETF? for a closer look at this issue]. 

As ETF issuers evolve their product lines and the industry continues to evolve, two new GDP-weighted ETFs have been  proposed by Van Eck to trade under their Market Vectors brand name. In a recent filing with the SEC, Van Eck announced its intention to launch a Market Vectors GDP International Equity ETF and a Market Vectors GDP Emerging Markets Equity ETF. The first fund would track the International Index, a rules-based benchmark intended to track the investable universe of publicly traded companies in countries outside of the U.S. Each country represented in the International Index would be weighted according to its gross domestic product (“GDP”), with individual constituent stocks for each country then selected using a modified market capitalization weighted float-adjusted methodology.  Country weightings in the International Index based on the GDP weighting factor are reviewed annually [also read Beyond EFA: Five Alternative EAFE ETFs].

Meanwhile the Emerging Markets Fund uses a similar strategy, it tracks the Emerging Markets Index, a rules-based benchmark intended to track the investable universe of publicly traded companies in emerging countries. Again, each country represented in the Emerging Markets Index is weighted according to its GDP, and underlying constituent stocks for each country are in turn selected using a modified market capitalization weighted float-adjusted methodology.

Benefits Of GDP Weighting

GDP-weighted funds have the potential to offer an allocation picture more representative of the global economy. According to MSCI, market cap weighted funds tend to be overweight in terms of exposure to easily accessible (and familiar) markets such as Canada and the UK while under-representing markets such as the BRIC nations as well as more developed economies such as Italy, Germany, and Spain. MSCI also states that GDP figures tend to be more stable over time when compared to the often volatile ups and downs of the equity markets. This ensures that weighting by GDP allocation figures stay relatively constant and do not get caught up in bull or bear markets.

GDP weighting also allows for higher exposure to fast growing countries; nations exhibiting slowing GDP growth will see their allocation in a GDP-weighted ETF gradually decline. Lastly, GDP weighted indexes may underweight countries with relatively high valuation compared to market-cap weight indexes. That’s because a GDP-weighted index would break the link between country weighting and stock price–similar to the case for the fundamental-weighted ETF products now available. GDP-weighted indexes do not care about how particular stock markets are doing, instead focusing on the total economic value of the country in order to determine allocations [see Five Bold Predictions For The ETF Industry].

Possible Breakdowns

With the international fund, higher allocations can be expected to countries like Germany, France, and Italy, which remain on the list of the world’s 10 largest economies but generally are forgotten in many international ETFs. For example, the most popular EAFE ETF, the iShares MSCI EAFE Index Fund (EFA) offers about 20% of its holdings to the UK and a similar amount to France and Germany combined. This comes despite the fact that both France and Germany have larger economies than their British counterparts.

Meanwhile, for emerging markets, the most popular fund is the iShares MSCI Emerging Markets Index Fund (EEM) which currently has over $30 billion in assets. However, the fund allocates 13.1% to South Korea with just 12% going to India and Russia combined, even though (once again) these two nations both have a higher GDP than their more famous counterpart [also read Ticking Time Bomb Under EEM].

Should these funds be approved, it could offer investors an interesting and novel way to access international equity markets. These funds could also help to reduce the importance of market cap weighting and help to give investors a better and more balanced picture of international markets, spreading out assets more evenly instead of just focusing in on some of the world’s more accessible and liquid stock markets where some of the largest companies in the world trade [also read Ten Intriguing ETF Storylines].

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Disclosure: No positions at time of writing.