Geopolitics Is Redefining Diversification
“Diversification used to mean spreading money across markets. It now also means spreading it across political and institutional risks.”
For nearly 50 years, global investing has rested on an assumption so familiar that it rarely needed stating: that capital will find its most productive use wherever in the world that happens to be. But the world investors have grown used to — where free-flowing capital shifts almost frictionlessly across borders to its globally optimal allocation — is disappearing before our eyes.
I recently spent time with our Middle East team in Saudi Arabia, Kuwait and Abu Dhabi. In Kuwait, our hotel stood next to a skyscraper in ruins after an Iranian missile strike that had apparently been aimed at the hotel. It was a blunt reminder that these countries sit on the front line of great-power rivalry.
In many cases, the Gulf states are investing inward, building domestic capability rather than sending capital abroad. In a region famously hot and dry, they are nevertheless focused on building their own data centers. That tells me they have stopped assuming a world of reliable external partners, and exemplifies the conundrum facing middle powers today.
Canada makes the same point from the opposite direction. It has a nearly 9,000-kilometer (5,500-mile) land border with the U.S. and has gained enormously from shared geography, language and institutions. Yet it is now looking for ways to bypass that geography, even going so far as to discuss "associate membership" of the EU. Its inaugural Canada Investment Summit aimed to catalyze CAD 1 trillion of investment in Canada over five years from major international and institutional investors. Canada’s pitch, set out in a pair of CPP Investment Insights Institute working papers, rested on two themes we often discuss at MSCI: institutional strength and risk diversification.
Investors now have to think seriously about home bias and domestic development, about the decline of the geopolitical institutions they once took for granted, and about diversifying international political and financial risks. Diversification used to mean spreading money across markets. It now also means spreading it across political and institutional risks.
“Investors now have to think seriously … about the decline of the geopolitical institutions they once took for granted.”
That is where concentration comes in. By nature of their construction, market-cap indexes may inadvertently concentrate risk in particular issuers, industries and countries, and underweight places whose economic weight is much larger than their market weight. We contributed to the Canadian discussion with a paper of our own, Breaking Free of Market Concentration. It finds that the U.S. now accounts for close to two-thirds of world equity-market value, up from about half in the early 2000s, and that similar concentration has built up in fixed income and private capital.
Our benchmarks — public or private, equity or fixed income — reflect that concentration, and our decades of research point to ways investors worried about it can diversify their portfolios. Canada illustrates the point. Almost any systematic attempt at portfolio diversification would give it more weight: it is underrepresented in market-cap calculations relative to the scale of its economic activity, and its industrial mix, concentrated in financials, energy and materials, differs markedly from that of market-cap indexes. Energy, mining and materials, in particular, are core components of global supply chains — including for strategic industries such as defense.
“Our decades of research point to ways investors worried about [concentration] can diversify their portfolios.”
Just a few years ago, no one would have seen the need for an analysis like this, and our contribution would have been limited to public equity markets. Today we can study not only public equities but also private equity and infrastructure, and strategic themes such as supply chains, energy and defense. That breadth matters when the risks being diversified are no longer only financial.
The lesson goes beyond Canada. Some of the world’s largest sovereign wealth funds and pension funds are interested in what similar studies would find for their own economies. Every investor can ask a version of that question: Where is my risk concentrated, and does that concentration reflect the world I expect to invest in? What new investment opportunities can be created in a fragmenting world?
These are questions that active investors must now confront actively, wherever they may be in the world, and however that may affect their investment opportunity set. The Gulf states and Canada have already started that adjustment. Investors everywhere need to join them.
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MSCI World GDP Index
The MSCI World GDP Weighted Index is based on the flagship MSCI World Index, its parent index, and includes large and mid cap stocks across Developed Markets countries. The index uses a different weighting scheme than its cap weighted parent index, however. The weight of each country in the index is derived from its economic size (using GDP data) rather than the size of its equity market.
Breaking Free of Market Concentration: Canada is a case study for deliberate diversification
U.S. equities hold close to two-thirds of world market value. See why GDP weighting — and an under-owned Canada — offer a governance-defensible way to break the concentration.
Market Concentration and the Global Index Opportunity Set
We examine how MSCI’s GIMI™ methodology has adapted to market concentration, and flex four methodology dimensions to gauge how those scenarios affect breadth, liquidity, size integrity and resilience.
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