What is the most relevant definition of “global equity markets”? Equity indices, as traditionally defined on the basis of market capitalisation, have ceased to accurately reflect the average performance of global stock markets. Their performance currently generates very limited information about the general state of the global economy or stock markets as the lion’s share of recent returns have been determined by an increasingly small number of stocks and currencies. These highly concentrated global benchmarks also create systematic risks to financial markets. Index providers, global investors, and the fund management industry as a whole need to alter or at least nuance the default definition for “global equity market” risk and return. Moreover, the recent parabolic concentration skew of these global indices risks impairing the active fund landscape.
What is the global equity market, anyway?
There are diverse ways to determine an index basket. Some are calculated using a price-weighted methodology, for instance the Dow Jones and the Nikkei 225 in Japan, where a higher share price effectively means a higher weight in the index. Market capitalisation weighted indices, which multiply a company’s number of shares outstanding by the share price to determine its weight in the index basket, represent the vast majority of benchmarks, including the MSCI World and ACWI (All Country World) indices. There are also equal-weighted index baskets, where every stock in the index has the same weight, regardless of price. Most indices calculated by MSCI are available in equal-weighted form.
The methodologies can generate diverse outcomes for returns and risk over time. Historically, there have been small difference between market-cap weighted and equal-weighted indices as can be seen in appendix charts, but their risk profiles today differ considerably due to degrees of concentration. In 2024, the former version of the MSCI World outperformed the latter by 11 percentage points, the highest ever difference between the two[1].
It is also interesting to observe that the highest weighted stock in the market-cap weighted MSCI Small and Mid-Cap index is 0.3 percent. The top 10 positions in the basket are less than 3 percent in aggregate. In the MSCI Emerging Markets Index, the largest stock even briefly exceeded the 10 percent threshold limit which is applicable in the UCITS framework. It is probably safe to conclude that the valuation gap and concentration risk between the market cap-weighted and equal-weighted indices reached parabolic levels at the end of 2024.
Global passive equity flows – the endless bidder
The main driver behind the parabolic spread described above is the constant flow of passive capital into equities which is effectively mechanically put to work through global market capitalisation-weighted indices. According to Lipper data, 2023 saw passive funds attract inflows of $466 billion to overtake total assets in actively managed funds for the first time. While the statistics for 2024 are not yet available, it is fair to assume that the trend continued last year.
These flows are automatically steered towards the companies with the largest market capitalisation in the index without any consideration of valuation or concentration risks. Many investors are largely unaware of these risks and usually invest on the basis of low asset management fees rather than prioritising superior diversification or attractive valuations in global funds. Financial commentators also frequently complain about the “poor” performance of actively managed funds, but forget several important aspects, such as downside protection, diversification and investor access to low valuations.
It is clear that the constant flow of capital into passive and semi-passive global equity products is seriously distorting equity markets and removing the natural price discovery mechanism in many areas, for example in the small and mid-cap complex. Heading into 2025, it is safe to say that these distorting forces have reached ground-breaking levels and a financial apocalypse stemming from this lack of diversification is a growing threat to passive equity investors.
Comparing Apples with Oranges
To compare and evaluate the performance of truly active funds against these highly skewed market capitalisation-based indices risks impairing the active investing landscape. The purpose of a fund evaluation exercise is to measure “skill” or the ability of the active fund manager to “outperform” versus a specific and investable universe of stocks. An active global equity manager with the mandate to construct a diversified global portfolio with a balanced risk/reward from an absolute perspective, would probably not invest 70 or 80 percent of assets in one country or currency, as is currently the case with the MSCI World Index. Active value managers naturally constrained by valuation hurdles like us, also logically do not invest into the elevated pricing of the largest companies in global market capitalisation-weighted benchmarks.
Rising concentration and valuation levels in global equity benchmarks are driving the creation of increasingly unbalanced portfolios. Alarmingly, the current situation has forced many global funds into a handful of stocks with specific characteristics that are not judged by the same profit standards as “normal” companies which are not included in global index baskets. Active managers are forced to abandon their long-running – and in many cases – successful strategies to load up on potentially overvalued and over-owned US equities, just to protect their careers. If this continues, the fund industry risks becoming entirely homogenous with only a few very large passive investment houses providing identical products that will ultimately polarise global equity valuations.
A look back at 2024
In 2024 (USD), the average global stock, defined as the MSCI ACWI Equal Weighted Index, returned 5.9 percent while a market capitalisation weighted global index returned 18.0 percent. At the end of the year, the US equity market accounted for 67 percent of the MSCI ACWI World equity index basket. These 589 stocks constitute 22 percent of the stocks listed in the index. The MSCI World excluding the US returned 5.3 percent in the year.
SKAGEN as an active value manager
SKAGEN is one of a shrinking number of investment boutiques which have resisted the pressure to invest according to the skewed market-capitalised weighted global indices. Suffice it to say, 2024 represented a very challenging year for our funds, if not the most difficult on record since SKAGEN was founded in 1993. However, we are proud of our contrarian and value-based investment philosophy and diversification across different sectors and geographies. Our global portfolios (The Apples) are measured against increasingly distorted and concentrated indices (The Oranges), and the reference point risks losing relevance. As we head into 2025, we will continue to target world-class returns, based on sound investing principles. We believe that this approach will deliver the best long-term returns for our clients and protect them from the growing risks inherent in global equity indices.
[1] Source: MSCI. MSCI World Indices in USD.