July 2016
THE WEIGHTING IS THE HARDEST PART:
SUPERIORITY OF EQUAL WEIGHTING
COUNTRIES IN EMERGING AND
FRONTIER MARKETS
Tim Atwill, Ph.D., CFA
Head of Investment Strategy
Diversification is commonly considered to be the “free lunch” of
portfolio management, in that higher expected returns with lower
volatility are achievable simply by diversifying. However, how
should this diversification be achieved? The answer depends on
investors’ predictions of volatility, correlation, and the expected
growth rates of the portfolio constituents. While it is already a
challenge to get “good” estimates for these metrics in most asset
classes, it is especially true in emerging markets, where countrylevel macro-economic shocks are frequent and unpredictable, and
stock-level information is often not reliable. Under these conditions,
we would contend that the naïve equal-weighted portfolio is the
rational choice for achieving diversification.
Tianchuan Li
Quantitative Analyst
Mahesh Pritamani, Ph.D., CFA
Senior Researcher
Parametric
1918 Eighth Avenue
Suite 3100
Seattle, WA 98101
T 206 694 5575
F 206 694 5581
www.parametricportfolio.com
©2016 Parametric Portfolio Associates® LLC.
‌Parametric / July 2016
The Weighting Is the Hardest Part
It is this perspective which informs Parametric’s Emerging Markets strategy. We observe that in
the emerging markets, country-risk is paramount, and each country experiences high levels of
volatility, and exhibits low correlation with other countries. Further, given the dynamic state of market
leadership, where the best performing country one year can easily be the worst performing country
the next, we maintain that assuming each country has a similar expected return is entirely reasonable.
Taken together, these observations argue for the superiority of an equal-weighted country portfolio in
the emerging-markets asset class. However, there are large implementation obstacles to holding an
equal-weighted portfolio, given the high transaction costs and vast differences in market capitalizations
across emerging-market countries. Accordingly, Parametric commonly refers to its strategy as a
modified equal-weighted portfolio, which attempts to gain the advantages of the theoretical equalweighted portfolio, while managing these implementation realities.
In recent conversations, we have encountered skepticism about the superiority of an equal-weighted
portfolio in the emerging markets, as many investors view diversification as primarily a tool for volatility
reduction, and not as a potential source of excess return. In this brief, we use historical data to show
that an equal-weighted country portfolio in the emerging markets generates both lower volatility and
higher returns than the market-cap index. We also show a similar result for frontier markets. It is this
superior risk/return profile of the equal-weighted country portfolio that Parametric targets with its
emerging-markets strategy.
COUNTRY WEIGHTING: EQUAL WEIGHT VERSUS MARKET CAPITALIZATION
For our analysis, we use MSCI country-level index returns and market-capitalizations. Each month, we
then calculate two return streams from this data, which correspond to applying two distinct weighting
schemes to the country-level index returns:
• The first is the equal-weighted average of the month’s country returns, for each country in the
MSCI Emerging MarketsSM Index as of the prior month-end. This is equivalent to an equallyweighted country portfolio, rebalanced monthly back to equal weights.
• The second is the market-cap weighted average of the month’s country returns, for each country
in the MSCI Emerging Markets Index at the prior month-end. Note that this will approximate the
Index returns, but is not identical due to corporate actions and index reconstitutions which take
place intra-month.1
1
Our monthly data series tracks the
performance of the official MSCI
Emerging Markets and MSCI
Frontier MarketsSM Indexes closely
at an annualized tracking error of
0.18% and 0.85% respectively. As
the objective of the paper is to show
how changing the country weighting
scheme from cap-weighting to
equal-weighting affects performance
and risk characteristics relative to
one another, the fact that our data
doesn’t track the official index
returns perfectly is not a source of
concern.
These return figures are calculated for every month over a 15-year period from 2001 to 2015. We
also perform the same analysis for frontier markets, but due to data availability, we can only analyze
the 10-year period from 2006 to 2015. Note that transaction costs are not reflected in this analysis,
as we are not claiming such a portfolio is implementable; only that it possesses desirable risk/return
attributes. The results of these calculations are presented in Figure 1.
©2016 Parametric Portfolio Associates® LLC.
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‌Parametric / July 2016
The Weighting Is the Hardest Part
Figure 1: Annualized Performance of Emerging-Market and Frontier-Market Portfolios
Emerging-Market (2001-2015)
Country Weighting Scheme
Return (Annualized)
Risk (Annualized Standard Deviation)
Sharpe Ratio
Frontier-Market (2006-2015)
Country Weighting Scheme
Cap-Weight
Equal-Weight
Cap-Weight
8.54%
11.77%
-1.96%
1.63%
22.84%
20.83%
19.11%
18.82%
0.57
-0.10
0.37
Equal-Weight
0.09
Excess Return (vs. Cap-Weight)
3.23%
3.60%
Tracking Error (vs. Cap-Weight)
5.95%
9.06%
0.54
0.40
Information Ratio
Source: Parametric and MSCI as of 12/31/2015. Performance is provided for hypothetical portfolios and is derived from
the MSCI Emerging Markets Index and the MSCI Frontier Markets Index. It is provided for illustrative purposes only. It does
not represent the experience of any investor. It is not possible to invest directly in an index; they are unmanaged and do not
reflect the deduction of advisory fees, brokerage commissions and other expenses. It is not a recommendation to buy or sell
any security or to adopt any investment strategy. All investments are subject to the risk of loss.
Figure 1 gives ample evidence of the power of equal weighting in emerging and frontier markets.
In both cases, the equally-weighted portfolio outperformed its market-cap equivalent by over 3%
(annualized), and, in both cases, this outperformance was achieved with lower volatility. These
attractive characteristics come about entirely through the simple application of the naïve equalweighting diversification scheme, as the only difference between the two return streams was the
choice of weighting. As such, Figure 1 demonstrates how diversification can be a material source of
excess return in markets with highly differentiated and volatile country components.
To get a better understanding of the performance pattern between equal-weighting and cap-weighting
countries, in Figure 2 we plot the annual performance differences between the two portfolios, for the
case of emerging markets.
Figure 2: Excess Return of Equal-Weighted Versus Capitalization-Weighted Emerging-Market Country
Portfolios, 2001-2015
15.00%
10.00%
5.00%
0.00%
-5.00%
-10.00%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Emerging Markets (Equal-Weight and Cap-Weight)
Source: Parametric and MSCI as of 12/31/2015. Performance is provided for a hypothetical portfolio and is derived from
the MSCI Emerging Markets Index. It is provided for illustrative purposes only. It does not represent the experience of any
investor. It is not possible to invest directly in an index; it is unmanaged and does not reflect the deduction of advisory fees,
brokerage commissions and other expenses. It is not a recommendation to buy or sell any security or to adopt any
investment strategy. All investments are subject to the risk of loss.
©2016 Parametric Portfolio Associates® LLC.
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‌Parametric / July 2016
The Weighting Is the Hardest Part
For emerging markets, the equal-weighted country portfolio demonstrates remarkable consistency,
outperforming the market-cap weighted portfolio in twelve of the fifteen years. The three years of
underperformance correspond to notable outperformance by large constituents in the index, with
Brazil’s dramatic 128% rise in 2009, and China’s market-beating rallies in 2013 and 2015 being the
key detractors from relative performance.
For frontier markets, the equal-weighted portfolio demonstrates a quite different quality of consistency,
as shown in Figure 3.
Figure 3: Excess Return of Equal-Weighted Versus Capitalization-Weighted Frontier-Market Country
Portfolios, 2006-2015
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
-10.00%
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Frontier Markets (Equal-Weight and Cap-Weight)
Source: Parametric and MSCI as of 12/31/2015. Performance is provided for a hypothetical portfolio and is derived from
the MSCI Frontier Markets Index. It is provided for illustrative purposes only. It does not represent the experience of any
investor. It is not possible to invest directly in an index; it is unmanaged and does not reflect the deduction of advisory fees,
brokerage commissions and other expenses. It is not a recommendation to buy or sell any security or to adopt any
investment strategy. All investments are subject to the risk of loss.
In this case, the equal-weighted portfolio demonstrates a lower degree of consistency, only
outperforming in four of the ten years. This reflects the extreme concentration which has been
characteristic of the MSCI Frontier Markets Index, where a material part of the Index has been
contained in just three to five countries. In addition, this concentration has primarily been in economies
which are heavily reliant on the export of crude oil for their economic growth. Specifically, the top five
constituents have typically included U.A.E, Qatar, and Kuwait (all Persian Gulf states) and Nigeria
(the largest African exporter of crude oil). This dynamic in frontier markets makes the excess return of
the equal-weight portfolio more of a “feast or famine” situation, dependent upon the relative strength
of the oil-based economies. The reduced consistency in returns reflects this fact, but we note that
the magnitude of the equal-weighted portfolio’s outperformance dwarfs that of its underperformance,
resulting in the equal-weighted portfolio outperforming strongly over the entire sample period.
WHY DO EQUAL-WEIGHTED PORTFOLIOS OUTPERFORM?
There are many viewpoints as to the source of the above outperformance. As mentioned, it may be
the natural outcome of modern portfolio theory, applied to an environment with attractive volatility
and correlation patterns which make it ripe for benefitting from diversification. Another perspective is
to note that an equal-weighted portfolio implicitly assumes a monthly rebalancing trade, and so this
©2016 Parametric Portfolio Associates® LLC.
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‌Parametric / July 2016
The Weighting Is the Hardest Part
outperformance may simply reflect the harvesting of a rebalancing premium2. A further perspective
sees this outperformance as simply mining the “small country premium”, as smaller countries have
historically outperformed versus larger countries in the emerging markets3. It is unlikely that any
of these are complete explanations, but instead each thesis focuses on different aspects of the
same phenomena: that diversifying a portfolio’s country exposure, and then rebalancing to keep this
diversification intact, can yield superior performance in the emerging markets.
CONCLUSION
At the outset of the paper, we noted that we have encountered skepticism about the superiority of an
equal-weighted portfolio in the emerging markets, as many investors view diversification as primarily a
tool for volatility reduction, and not as a source of excess return. We have shown, using historical data,
that an equally-weighted country portfolio in the emerging markets generates both lower volatility and
higher returns than the market-cap index. Parametric’s Emerging Markets strategy follows a similar
investment philosophy as the equal-weighted methodology presented here and differs from it only for
pragmatic implementation reasons. It uses a tier-based weighting scheme to increase country-level
diversification while reflecting the vast dispersion in country market sizes. It also uses a trigger-based
rebalancing methodology to maintain this increased level of diversification, while acknowledging the
high transaction costs encountered in the developing world. In this way, the strategy tries to lock in
the risk/return benefits of equal-weighting countries demonstrated in Figure 1, while avoiding the
elevated implicit and explicit costs such a naïve portfolio would incur in reality.
2
Bouchey, P., Nemtchinov, V., and
Wong, L., “Volatility Harvesting in
Theory and Practice”, Journal of
Wealth Management, Vol. 18, No.
3, Winter 2015: 89-100.
3
Li, Tianchuan, & Pritamani,
M., “Country Size and Country
Momentum Effects in Emerging and
Frontier Markets”, The Journal of
Investing 24.1, 2015: 102-108.
©2016 Parametric Portfolio Associates® LLC.
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‌Parametric / July 2016
About Parametric
Parametric Portfolio Associates® LLC (“Parametric”),
headquartered in Seattle, WA, is a leading global asset management firm, providing investment strategies
and customized exposure management to institutions
and individual investors around the world. Parametric offers a variety of rules-based, risk-controlled
investment strategies, including alpha-seeking equity,
alter-native and options strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management.
Parametric is a majority-owned subsidiary of Eaton
Vance Corp. and offers these capabilities through
investment centers in Seattle, WA, Minneapolis, MN
and Westport, CT (home to Parametric subsidiary
Parametric Risk Advisors LLC, an SEC-registered
investment adviser).
Disclosure
This information is intended solely to report on investment strategies and opportunities identified by
Parametric. Opinions and estimates offered constitute
our judgment and are subject to change without
notice, as are statements of financial market trends,
which are based on current market conditions. We
believe the information provided here is reliable, but
do not warrant its accuracy or completeness. This
material is not intended as an offer or solicitation for
the purchase or sale of any financial instrument. Past
performance is not indicative of future results. The
views and strategies described may not be suitable
for all investors. Investing entails risks and there can
be no assurance that Parametric will achieve profits or
avoid incurring losses. Parametric does not provide
legal, tax and/or accounting advice or services.
Clients should consult with their own tax or legal
advisor prior to entering into any transaction or
strategy described herein.
Charts, graphs and other visual presentations and text
information were derived from internal, proprietary,
and/or service vendor technology sources and/or
may have been extracted from other firm data bases.
As a result, the tabulation of certain reports may not
precisely match other published data. Data may have
originated from various sources including, but not
©2016 Parametric Portfolio Associates® LLC.
The Weighting Is the Hardest Part
limited to, Bloomberg, MSCI/Barra, FactSet, and/
or other systems and programs. Parametric makes
no representation or endorsement concerning the
accuracy or propriety of information received from any
other third party.
Perspectives, opinions and testing data may change
without notice. Detailed back-tested and/or model
portfolio data is available upon request. No security,
discipline or process is profitable all of the time. There
is always the possibility of loss of investment.
This material contains hypothetical, back-tested
and/or model performance data, which may not be
relied upon for investment decisions. Hypothetical, back-tested and/or model performance results
have many inherent limitations, some of which are
described below. Hypothetical returns are unaudited,
are calculated in U.S. dollars using the internal rate of
return, reflect the reinvestment of dividends, income
and other distributions, but exclude transaction costs,
advisory fees and do not take individual investor taxes
into consideration. The deduction of such fees would
reduce the results shown.
The MSCI Emerging Markets Index is broad-based
and is a free float-adjusted market capitalization index
calculated total return and net of foreign withholding
taxes that is designed to measure equity market performance in the global emerging markets. The MSCI
Frontier Markets Index is a free float-adjusted
market capitalization index that is designed to measure equity market performance of frontier markets.
“MSCI” and MSCI Index names are service marks
of MSCI Inc. (“MSCI”) or its affiliates. The Parametric Emerging Markets Strategy is not sponsored,
guaranteed or endorsed by MSCI or its affiliates.
MSCI makes no warranty or bears any liability as to
the results to be obtained by any person or any entity
from the use of any such MSCI Index or any data
included therein. Please refer to the MSCI website for
complete details on all indices.
Model/target portfolio information presented, including, but not limited to, objectives, allocations and
portfolio characteristics, is intended to provide a
general example of the implementation of the strategy
and no representation is being made that any client
account will or is likely to achieve profits or losses
similar to those shown. In fact, there are frequently
sharp differences between hypothetical performance
results and the actual results subsequently achieved
by any particular trading program. One of the limitations of hypothetical performance results is that they
are generally prepared with the benefit of hindsight. In
addition, simulated trading does not involve financial
risk, and no simulated trading record can completely
account for the impact of financial risk in actual trading. For example, the ability to withstand losses or
to adhere to a particular trading program in spite of
trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or
to the implementation of any specific trading program
which cannot be fully accounted for in the preparation
of hypothetical performance results and all of which
can adversely affect actual trading results. Because
there are no actual trading results to compare to the
hypothetical, back-tested and/or model performance
results, clients should be particularly wary of placing undue reliance on these hypothetical results.
Global market investing, (including developed,
emerging and frontier markets) carries additional risks
and/or costs including but not limited to: political,
economic, financial market, currency exchange,
liquidity, accounting, and trading capability risks.
Future investments may be made under different
economic conditions, in different securities and using
different investment strategies. The currency used in
all calculations is the U.S. dollar. Currency exchange
may negatively impact performance.
All contents copyright 2016 Parametric Portfolio
Associates® LLC. All rights reserved. Parametric
Portfolio Associates, PIOS, and Parametric with the
iris flower logo are all trademarks registered in the
U.S. Patent and Trademark Office.
Parametric is located at 1918 8th Avenue, Suite
3100, Seattle, WA 98101. For more information
regarding Parametric and its investment strategies, or
to request a copy of Parametric’s Form ADV, please
contact us at 206.694.5575 or visit our website,
www.parametricportfolio.com.
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