AgPa #3: Measuring the World’s Assets (1/2)

The Global Market Portfolio (2021)
Gregory Gadzinski, Markus Schuller, Andrea Vacchino
The Journal of Portfolio Management 47(8), 151-163, URL

The Global Capital Stock: Finding a Proxy for the Unobservable Global Market Portfolio (2018)
Gregory Gadzinski, Markus Schuller, Andrea Vacchino
The Journal of Portfolio Management 44(7), 12-23, URL

Compared to the heavy econometrics of the last one, this week’s AGNOSTIC Paper is completely harmless. It is a very practical paper that attempts to translate an important theoretical concept into practice – the global market portfolio. The global market portfolio is the collection of all investment opportunities and each asset is weighted by its market value. It contains all stocks, bonds, real estate, land, and everything else that serves as a storehold of wealth.

So far the theory. But collecting data on all available assets and estimating their current market values is very difficult in practice. The contribution of the paper is to tackle this issue and to develop two reasonable proxies of the global market portfolio. The first is investable via 87 ETFs. The second is closer to the theoretical idea but requires private funds that are only available for institutional investors.

As shown in the boxes above, the authors already examined the global market portfolio in 2018. I mainly focus on the 2021-paper, but I still want to give you the full references. I also refer to the 2018-paper for some methodological details. Both papers are definitely worth reading and very relevant for real-world investing. The global market portfolio is the broadest possible benchmark and the most accurate form of passive investing. It also quantifies the world in which we as investors operate.

Similar to the previous posts, I divided this one into the following parts:

• Setup and Idea
• Data and Methodology
• Important Results and Takeaways
• Conclusions and Further Ideas

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

Those who went through courses on portfolio theory may already know it, but let’s do an example to illustrate why the market portfolio is such a powerful concept.¹Specifically, it is derived from Markowitz’s (1952) portfolio theory, Tobin’s (1958) two-fund separation, and Sharpe’s (1964) Capital Asset Pricing Model.

Suppose there are only two stocks, Apple and Microsoft. In addition to that, there are three (very rich) investors with a total wealth of $0.5T each. The market capitalization of Apple and Microsoft are currently $2.55T and $2.05T, respectively.²Data from Microsoft Excel/Office 365 as of May 6, 2022. Investor 1, let’s call him Steve, loves the Mac and invests his entire $0.5T in Apple stock. Investor 2, Bill, is more the PC-guy. Consequently, he invests his $0.5T into Microsoft. Finally, we have Investor 3 who is a tech-fan but thinks Apple is somewhat cooler than Microsoft. Therefore, he invests 66% of his money in Apple and the remaining 34% in Microsoft. That’s $0.33T and $0.17T, respectively.

Own example as illustration. Market capitalization data are from Microsoft Excel/Office 365.

The table summarizes what I have just written. However, there is a problem. Apple and Microsoft are collectively worth $4.6T, but the three investors only hold $1.5T of this value. Such a situation is the nightmare of any economist because the market is not in equilibrium. Someone must own the remaining $3.1T of the two companies.³Assuming that the company value is given, which I do here. So let’s introduce Investor 4, Larry, who is super-rich and owns the remaining shares. Larry has no opinion about technology and does not consider himself smart enough to judge which company is the better investment. Therefore, he just looks what the other three investors are doing and takes the average of their portfolio weights.⁴For those who are aware of the finance literature, this example is of course an illustration of Sharpe’s (1991) Arithmetic of Active Management.

Own example as illustration. Market capitalization data are from Microsoft Excel/Office 365.

The average of 100%, 0%, and 66% is about 55%. Consequently, Investor 4 (Larry) invests roughly 55% of his wealth into Apple. With the same logic, he puts the remaining 45% into Microsoft. Now we have a situation that economists like. The total wealth of the four investors is equal to the total value of the two companies ($4.6T) and no piece of either company is left un-owned. The market is therefore in equilibrium.

Holding the Market Portfolio = Passive Investing

Let’s examine the market portfolio in this simple example. As a reminder, the market portfolio captures all available assets weighted by their market value. So we have Apple and Microsoft that are collectively worth $4.6T. The weight of Apple in the market portfolio is $2.55T / $4.6T = 55%. Similarly, the weight of Microsoft is $2.05T / $4.6T = 45%. You may have noticed that these are the exact same portfolio weights as Larry’s (Investor 4) who just took the average of all other investors.

This is not by coincidence and generally true. The market portfolio tells us the average position of all investors for each asset. Investors who deviate from this market portfolio are called active. For example, Steve bets that Apple is a better investment than perceived by the other investors and over-weights the stock in his portfolio (100% vs. 55% in the market portfolio). He may be right but there is catch. Bill, who is also very smart and wants to make money, bets directly against him and under-weights Apple (0% vs. 55%).

In the end, only one of the two can be right. To be a successful active investor, you therefore need some form of unique information or insight that makes you smarter than the rest and justifies your deviations from the market portfolio. I don’t say active is bad. But you should always keep in mind that the stock you are over-weighting is under-weighted by someone else.

Passive investors don’t play this game and admit that they have no reason to believe they are better than average. Therefore, they just buy the market portfolio and are free-riding on the opinions and analyses of active investors. It is a bit like Amazon reviews. A single review can be misleading but the average usually tells you something about the quality of the product. It works the same way with assets. The average portfolio weight reflects the views of many smart people who all want to make money. In particular for stock markets, following this consensus is a good starting point. In fact, many empirical analyses show that most active investors overestimate themselves and perform worse than proxies for the market portfolio.⁵For example, Carhart (1997) or Fama and French (2010).

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Passive investing therefore became a very popular strategy and has driven the recent growth of the ETF- and index-industry. Although the words “passive”, “ETF”, and “index” are often (falsely) used interchangeably, the most accurate and scientifically correct form of passive investing is to simply hold the market portfolio. Thus, having a good proxy for it is important and brings us back to the paper.

Data and Methodology

The methodology of the authors is straight forward but not easy to implement. To construct the global market portfolio they need all assets and their corresponding market values. They approach this issue in two steps. First, they divide the world into the following 11 asset classes and obtain aggregate values for each of them.⁶This is the focus of the 2018-paper. In the second step, they approximate the return of each asset class with ETFs and private funds.⁷This is the major contribution of the 2021-paper.

• Stock Markets
• Debt Securities and Bonds (Public, Financial Institutions, Non-Financial Corporates)
• Money Market Instruments and Cash (Non-Corporation)
• Securitized and Non-Securitized Loans
• Private Equity
• Real Estate (Non-Corporation)
• Land (Non-Corporation)

According to the authors, they determine the total value of these asset classes by using “[…] data from the most reliable public international sources from 2005 onward […]”. They do not mention these sources explicitly, but provide detailed explanations in the 2018-paper.

For stock markets, they use data from the World Federation of Exchanges (WEF). Statistics on debt securities, bonds, cash, and loans are available from central banks and the Bank of International Settlements (BIS).⁸The authors also use a variety of other databases, for example from the Securities Industry and Financial Markets Association (SIFMA) or from the Association for Financial Markets in Europe (AFME). To estimate the global value of real estate and land, the authors rely on previous research, data from organisations such as the OECD, and statistical surveys. For private equity, they also rely on existing studies and estimate the aggregate value from the GDP-contribution of small- and medium-sized private firms.

Of course, this is a patchwork of data sources that will almost certainly suffer from some inconsistencies and errors. I want to emphasize that I am not saying this to criticize the paper. Collecting data on all of the world’s assets is very difficult and I appreciate the authors’ effort to tackle this issue. They transparently explain all assumptions and provide plausible justifications for each of them. So the data is certainly not perfect but probably among the best we have.

The authors also try to avoid double-counting wherever possible. Why is this important? A lot of the world’s real estate, land, and cash belongs to corporations. Therefore, the value of these assets should be already reflected in the companies’ market value.⁹For example, the real estate value of Apple’s headquarter should be part of its market capitalization. This is also one of the reasons why the authors exclude commodities and precious metals. Probably most of the world’s commodities belong to corporations and their values should be reflected in the companies’ value. In addition to that, estimating the available stock of commodities is almost impossible. Nobody really knows how many tons of gold or coffee are currently existing in the world.

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With the aggregate value of the 11 asset classes, the authors already have the composition of the global market portfolio. In the next step, they select ETFs and private funds within each asset class to construct an investable benchmark. In doing so, the authors attempt to preserve as much granularity as possible. For example, they use individual ETFs for each country’s stock market instead of a global index.

In particular for their investable market portfolio and the illiquid asset classes, this again requires some approximations. Specifically, the authors use a global REIT index for real estate and two specialized indices for land. This is not perfect but over the long term, such indices tend to reflect the return profile of the underlying asset classes. Similarly, previous studies found that the return-profile of private equity is somewhat similar to that of small caps. Consequently, the authors approximate the return of private equity with a global small cap index.

For the non-investable market portfolio, the authors also include private investment funds that are only available for institutional investors. They obtain the value of private investment funds for private equity, land, and real estate from The Cambridge Associates, a high-quality data vendor. Including these private funds improves the coverage of assets. The non-investable benchmark is therefore closer to the true global market portfolio and offers better diversification.

Important Results and Takeaways

Global assets were worth about $667T in 2019

The first important takeaway is the global stock of capital. A the end of 2019, the world’s assets were worth about $667T. That is a pretty big number. But given the tremendous asset growth of the last two years, it is probably even larger for 2021.

Exhibit 1 of Gadzinski et al. (2021).

Another interesting observation is the continuous growth. Except for 2008 and 2015, the total value has not declined relative to the year before. This of course coincides with the unique decade of rising asset prices and low interest rates.

Exhibit 2 of Gadzinski et al. (2021).

The second chart shows the composition of the market portfolio in each year. I want to highlight two points. First, stock markets are a relatively small fraction of the world’s assets. Although they receive a lot of attention, they made up just 14% of the market portfolio in 2019. Second, real estate and private equity are the single largest asset classes of the world. Collectively, illiquid assets (real estate, private equity, land) made up more than 40% of the market portfolio in 2019.

The share of each asset class is relatively stable over time. But there are some exceptions. For example, the drawdown of stock markets between 2008 and 2010 is clearly observable. In addition to that, private equity and real estate became more important over time (32% in 2010 vs. 41% in 2019). This is consistent with the recent boom of private markets and the rise of alternative asset managers.

The investable market portfolio returned 4.7% p.a. from 2005-2020/Q1

Let’s turn the performance of this market portfolio. As mentioned above, the investable benchmark consists of 87 ETFs.¹⁰The authors list them in Exhibit 3 of the paper, although without weightings. For the portfolio backtest, the authors update the asset-class-weights semi-annually. The weights of the ETFs within their asset classes are updated monthly.

Exhibit 4 of Gadzinski et al. (2021).

From 2005 to the first quarter of 2020, the investable global market portfolio generated a return of 4.7% per year. The annualized volatility is 10.1% and the maximum drawdown was 35% during the financial crisis in 2008/09. Of course, both risk and return are lower than for global stock markets. But given the composition of the market portfolio, this is no surprise.

The non-investable market portfolio returned 5.9% p.a. from 2005-2020/Q1

The non-investable market portfolio follows the same methodology but also includes private investment funds for illiquid assets. Unfortunately, such funds are only available for institutional- or wealthy individual investors. As shown in the chart, those funds had a positive effect on both risk and return. The non-investable market portfolio achieved a return of 5.9% per year with a much lower annualized volatility of just 6.3%. The maximum drawdown during the financial crisis 2008/09 was also significantly lower at 20%.

Exhibit 5 of Gadzinski et al. (2021).

The better risk-return profile is a direct consequence of improved diversification and less frequent valuation. However, investing in private- or alternative-assets is not the holy grail. It involves higher costs of monitoring and introduces liquidity risk. For example, the authors mention that the Harvard endowment fund faced a 50% discount when trying to sell parts of their private equity investments in 2008. A substantial part of the higher return on private assets seems to be compensation for such liquidity risk.

Conclusions and Further Ideas

I like the two papers because they take a theoretical concept and put it into practice. The global market portfolio is something we should all care about. It is the ultimate benchmark for asset allocation and passive investing. However, this comprehensive version with all asset classes is certainly more relevant for institutions than for individual investors. I don’t want to own government bonds that deliver guaranteed negative real returns. So I am fine with deviating from the market portfolio at this point. But even within asset classes, the market portfolio is a powerful concept.

Take for example stock markets. A passive stock investor should hold all stocks in the world and weight them according to their market capitalization. This is not the same as just buying an ETF on some index. Even the MSCI World Index is not truly passive because it only captures developed markets. And although it also contains emerging markets, the MSCI All Country World Index is not passive either. It does not include frontier markets and small caps.¹¹Check the website of MSCI to get more information about this.

I don’t want to be too nerdy. But the point is, passive investing means holding all securities weighted by market values. Not more, not less. Some indices like the MSCI ACWI Index are good proxies for that, some others are not. For example, the Dow Jones Industrial Average captures only 30 US companies and does not weight them by market capitalization.¹²More information on this website. This has nothing to do with passive investing.

I think this is important to understand. But please don’t get me wrong. I don’t want to bash well-designed indices like the MSCI World. They are good proxies and more than sufficient for any practical application. Like the authors of the paper, we shouldn’t be too perfectionistic and work with the best we have. At the same time, we shouldn’t forget the underlying theory and don’t pay too much attention to the marketing of creative ETF-companies.

Of course, the two papers in this post are not the only ones that examine the global market portfolio. In fact, the first work in this direction was already done by Ibbotson et al. (1985). However, those early results are very different because financial markets developed tremendously since then. More recently, Doeswijk, Lam, and Swinkels (2014, 2019) provided another proxy for the global market portfolio. They focus more on public markets and therefore get somewhat different results. To get the full perspective, I will cover these two papers next week. So it is going to be a little series within the series.

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• AgPa #73: Country and Industry Momentum2023-12-17

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