Developed Countries
To appreciate the myopia of an exclusive investment focus on U.S. stocks and bonds, con- sider the data in Table 25.1 . The U.S. accounts for only about a third of world stock market capitalization. Clearly, investors can attain better risk–return trade-offs if they extend their search for attractive securities to both developed and emerging markets. Developed coun- tries have broad stock indexes that are generally less risky than those of emerging markets, but both offer opportunities for improved diversification. 1 Developed countries made up 68% of world gross domestic product in 2009. Our list also includes 20 emerging markets that make up 16.2% of the market capitalization of the world stock markets.
The first six columns of Table 25.1 show market capitalization over the years 2004–
2009 for developed markets. The first line is capitalization for all world exchanges, show- ing total capitalization of corporate equity in 2009 as $37.2 trillion, of which U.S. stock exchanges made up $12.3 trillion (33.1%). The next three columns of Table 25.1 show country equity capitalization as a percentage of the world’s in 2004 and 2009 and the growth in capitalization over the period. The large volatility of country stock indexes resulted in significant changes in relative size. For example, the U.S. weight in the world equity portfolio decreased from 42% in 2004 to 33% in 2009. The weights of the five larg- est countries behind the U.S. (Japan, U.K., France, Hong Kong and Canada) added up to 29% in 2009, so that in the universe of these six countries alone, the weight of the U.S. was only 54%. Clearly, U.S. stocks may not comprise a fully diversified portfolio of equities.
The last three columns of Table 25.1 show GDP, per capita GDP, and equity capitaliza- tion as a percentage of GDP for the year 2009. As we would expect, per capita GDP in developed countries is not as variable across countries as total GDP, which is determined in part by total population. But market capitalization as a percentage of GDP is quite variable, suggesting widespread differences in economic structure even across developed countries.
We return to this issue in the next section.
Emerging Markets
For a passive strategy one could argue that a portfolio of equities of just the six countries with the largest capitalization would make up 61.7% (in 2009) of the world portfolio and may be sufficiently diversified. This argument will not hold for active portfolios that seek to tilt investments toward promising assets. Active portfolios will naturally include many stocks or even indexes of emerging markets.
Table 25.2 makes the point. Surely, active portfolio managers must prudently scour stocks in markets such as the so-called BRIC nations (Brazil, Russia, India, China).
Table 25.2 shows data from the 20 largest emerging markets, the most notable of which is China with growth of 874% over the 5 years ending in 2009. But managers also would not want to have missed a market like Colombia (.36% of world capitalization) with a growth of 569% over the same years.
These 20 emerging markets make up 24% of the world GDP and 16% of world market capitalization. Per capita GDP in these countries in 2009 was quite variable, ranging from
$954 (Pakistan) to $18.576 (Czech Republic). Market capitalization as a perc entage of GDP
1 FTSE Index Co. [the sponsor of the British FTSE (Financial Times Share Exchange) stock market index] uses 14 specific criteria to divide countries into “developed” and “emerging” lists. Our list of developed countries includes all 25 countries that appear on FTSE’s list.
Market Capitalization Billions of U.S. DollarsPercent of WorldGrowth (%)GDP 2009 ($ bil) GDP per Capita
Market Capitalization as Percent of GDP 200420052006200720082009200420092004–200920092009 World31,70135,52543,10448,33326,78637,193100%100%17.3%57,53010,34865% United States13,34513,93415,60615,9219,56812,29942.133.127.814,27046,45086 Japan3,4864,4204,5054,2803,0873,27311.08.826.15,04939,73165 United Kingdom2,7302,9753,6923,7231,8372,7608.67.41.12,19835,966126 France1,4361,6672,3132,5721,4081,8284.54.927.32,63541,13569 Canada9601,2061,3991,6698931,4313.03.849.11,31939,388108 Hong Kong7067781,1201,6698531,3512.23.691.420929,596647 Germany1,1171,2191,5992,0201,0891,2663.53.413.33,23539,29339 Australia6417219331,1885971,1022.03.071.992043,268120 Switzerland8129211,1931,2518501,0492.62.829.248463,660217 Spain6356519261,0176497732.02.121.81,43835,48454 Italy7787861,0201,0705246632.51.8214.82,09035,95632 South Korea3565496558653906471.11.782.080016,49881 Netherlands6125437257773044591.91.2224.979047,24258 Sweden3433665104992353981.11.115.939843,898100 Singapore1541833144122223960.51.1157.416335,018243 Belgium2692703353591562480.80.727.946244,31454 Norway1371932673401232300.40.667.636979,17562 Finland1741982523411481800.50.53.624246,15074 Denmark1431632012311151620.50.413.730856,04953 Israel6785109156871480.20.4121.321629,81969 Austria87133173203761170.30.334.437445,60131 Greece105124174228801010.30.323.533831,50730 Portugal747110613665930.20.225.322020,52742 Ireland10611115713645640.30.2239.822753,95928 New Zealand4039414422330.10.1218.411026,01230 Rest of the world2,3883,2204,7807,2253,3626,1217.516.5156.318,667 Table 25.1 Market capitalization of stock exchanges in developed countries Sources: Market capitalization, Datastream; GDP and per capita GDP, www.cia.gov/library/publications/the-world-factbook/index.html.
Market Capitalization Billions of U.S. DollarsPercent of WorldGrowth (%)GDP 2009 ($ bil) GDP per Capita
Market Capitalization as Percent of GDP 200420052006200720082009200420092004–200920092009 Total emerging markets2,2302,9344,6546,9523,2856,0227.0%16.2%170.0%13,69144% Brazil3234076041,1365201,1501.03.1255.81,4827,45778 India3014086051,2854999920.92.7229.91,2431,07480 Russia1322247781,0723246860.41.8419.71,2558,96255 China591634216373455720.21.5874.44,7583,55412 Taiwan3323514374882714641.01.239.835715,552130 South Africa2252843333942253650.71.062.42775,655132 Mexico1712383463562123130.50.883.88667,79036 Malaysia1371421832491512300.40.667.42078,065111 Turkey831281352411061980.30.5140.05947,72733 Chile941111451801131960.30.5109.71509,059131 Indonesia6470120178821840.20.5187.85152,14336 Thailand8697107154811430.30.467.02664,03654 Colombia20424254821350.10.4569.42295,23459 Poland6377125169771090.20.372.642310,99226 Philippines2641609145760.10.2193.71591,62048 Peru1519556040650.00.2339.31274,31251 Czech Republic3038507744460.10.153.419018,57624 Argentina2124303636410.10.198.23017,36414 Hungary2833424619300.10.16.712412,53824 Pakistan2136374916250.10.116.016795415 Table 25.2 Market capitalization of stock exchanges in emerging markets Sources: Market capitalzation, Datastream; GDP and per capita GDP, www.cia.gov/library/publications/the-world-factbook/index.html.
ranges from 12% (China) to 132% (South Africa), suggesting that these markets are expected to show significant growth over the coming years, even absent spectacular growth in GDP.
The growth of capitalization in emerging markets over 2004–
2009 was very large (170%) and much more volatile than growth in developed countries, suggest- ing that both risk and rewards in this segment of the globe may be substantial.
Market Capitalization and GDP
The contemporary view of eco- nomic development (see, for example, deSoto) 2 holds that a major requirement for economic advancement is a developed code of business laws, institu- tions, and regulation that allows
citizens to legally own, capitalize, and trade capital assets. As a corollary, we expect that development of equity markets will serve as a catalyst for enrichment of the population, that is, that countries with larger relative capitalization of equities will tend to be richer.
Work by La Porta, Lopez-De-Silvanes, Shleifer, and Vishny indicates that, other things equal, market value of corporations is higher in countries with better protection of minority shareholders. 3
Figure 25.1 is a simple (perhaps simplistic, because other relevant explanatory vari- ables are omitted) rendition of the argument that a developed market for corporate equity contributes to the enrichment of the population. The slope of the regression line shown in Figure 25.1 is .45, suggesting that an increase of 1% in the ratio of market capitalization to GDP is associated with an increase in per capita GDP of .45%. It is remarkable that only 2 of the 25 developed countries lie below the regression line; only 2 of 20 low-income emerging markets lie above the line. A country like Norway that lies above the line, that is, exhibits higher per capita GDP than predicted by the regression, enjoys oil wealth that contributes to population income. Countries below the line, such as Pakistan, suffered from deterioration of the business environment due to political strife and/or government policies that restricted the private sector.
Home-Country Bias
One would expect that most investors, particularly institutional and professional investors, would be aware of the opportunities offered by international investing. Yet in p ractice,
2 Hernando de Soto, The Mystery of Capital (New York: Basic Books, 2000).
3 Rafael La Porta, Florencio Lopez-De-Silvanes, Andrei Shleifer, and Robert Vishny, “Investor Protection and Corporate Valuation,” Journal of Finance 57 (June 2002).
100 1,000 10,000 100,000
1 10 100 1,000
Per Capita GDP ($)
Developed countries Emerging markets Regression line
Pakistan India
Chile S. Korea Japan
Ireland Norway
U.S.
U.K.
Hungary Czech Rep.
Switzerland
Hong Kong
Brazil Russia
China
Market Capitalization (% of GDP)
Figure 25.1 Per capita GDP and market capitalization as percent of GDP, 2009 (log scale)
investor portfolios notoriously overweight home-country stocks compared to a neutral indexing strategy and underweight, or even completely ignore, foreign equities. This has come to be known as the home-country bias. Despite a continuous increase in cross-border investing, home-country bias still dominates investor portfolios. We discuss this issue fur- ther in Section 25.3.