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You’re unlikely to find stories on real (inflation-adjusted) interest rates on the financial front pages. But real rates are of major interest to economists and investment strategists. Many strategists think real interest rate trends are key in determining the level of asset prices: while falling real interest rates can boost market valuations, rising real rates may drag down returns across the board.

The IMF recently announced that China has surpassed the US as the world’s largest economy.  And just as China’s economic output has picked up steam, so too has the growth of China’s equity markets.   

But although Chinese equity markets have grown significantly in recent years, on a relative basis they are still dwarfed considerably by US equity markets. This relationship is evident in the market cap weighted FTSE All-World Index that excludes the mainland listed China A-shares. China only comprised 2.1% of the index as of month end November, relative to a 50.9% weighting for the US. Even with China A-shares included as demonstrated by the FTSE All-World non-R/QFII Index, China’s weight comprises only 3.9%.

Economic experts have long predicted China’s rapidly growing economy would someday surpass the U.S. as the world’s largest. According to the International Monetary Fund (IMF), this expectation has at last materialized. On December 4, the IMF released data revealing that by year end China will – in purchasing power parity (PPP) terms – produce $17.6 trillion in GDP, narrowly exceeding the $17.4 trillion in economic output produced by the U.S.

There can be no question about the popularity of ETFs based on methodologies other than standard capitalization weighting. But within this category there some big and important differences. One of the most significant is between funds that track smart beta – i.e. non-cap weighted indexes, and actively managed ETFs that dispense with the idea of tracking an index altogether.

The behavior of a capitalization-weighted index may be heavily influenced by a few large constituents. One simple way of addressing such concentration risk is to change the construction methodology; instead of weighting constituents by their market size, weight them equally.

But while equal weighting reduces concentration by making each index constituent’s index weight equal, it doesn’t address the fact that constituents have different risk levels, nor that the performance of certain constituents may be highly correlated.

With the media frenzy surrounding the recent Alibaba IPO, leading global index providers also came under the spotlight as the e-commerce giant’s stock was notably absent from their indexes.  Alibaba was not eligible for the FTSE Global Equity Index Series (GEIS) primarily due to its sole listing as an ADR, without an underlying ordinary share listing.

As market participants continue to seek diversification, GDP weighted indexes are attracting increasing interest.  Similar to fundamentally weighted indexes, GDP weighted indexes are designed to address the potential concentration risks presented by traditional cap-weighted indexes. However, instead of weighting securities by fundamental size, GDP weighted indexes assign country weights by proportionate share of GDP.    

Capitalization weighted indexes, the standard type of equity market benchmark, may show signs of concentration. This means that the behavior of the index as a whole is influenced to a great extent by a small number of large-cap stocks.

Index concentration can be measured using a Lorenz curve. This shows the cumulative weighting (in percent) of the first x percent of index stocks.

There are several different approaches to constructing indexes with risk management in mind. All follow systematic, transparent rules, but they have subtle differences. But how are these different indexes actually constructed – how are their components selected – to achieve the desired result? 

While blue chips continue to post gains for the fifth consecutive year, over the past few months small cap stocks have ceased to participate in the rally.  Indeed, the recent weak performance of some of the most widely used small cap indexes has been making financial news headlines. However, while small cap indexes as a whole have underperformed, the fundamentally weighted FTSE RAFI US 1500 Mid Small Index hasn’t fared as poorly as the market capitalization weighted Russell 2000.  Such differences underscore how index construction can affect performance in different market environments.