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Why a total world equity index tracker is the only index fund you need

Photo of Lars Kroijer hedge fund manager turned passive index investing author

Making the case for world equity index trackers is former hedge fund manager turned author Lars Kroijer, an occasional contributor to Monevator. His book, Investing Demystified, is focused on index fund investing.

I believe the only equity exposure you should buy is the broadest, cheapest, and most tax efficient – which is a total world equity index tracker.

Most Monevator readers are probably already willing to accept the following points, which in my view will massively improve your returns over time:

1. You accept that like most investors you don’t have an ability to outperform the financial markets (a so-called ‘edge’) and as a result you agree that you should invest in index tracking products. In other words you’re what I call a ‘rational investor’.

2. You agree that keeping trading to a minimum and investing tax efficiently with the lowest fees will boost your returns in the long run.

3. You accept that to have a hope of decent long-term returns you should have some equity exposure, as the dull returns that safer bonds or cash in the bank provide (which may not currently even beat inflation) mean those assets are very unlikely to do the job alone.

So having agreed to all that, the question is which equities should you own?

Investing without edge

From the perspective of the rational investor – an investor accepting and embracing the fact they don’t have an edge in the market – each dollar, pound, or euro invested in the various stock markets around the world is presumed to be equally smart.

If the markets say a share in Apple is worth $125 and a share in Microsoft is worth $40, then we as rational investors don’t have a preference for owning one of those shares over the other, at those prices.

If we did have a preference, then we would effectively be saying that we know more about the future movements in share prices than the aggregate market does.

As rational investors, we don’t believe that’s true.

We believe that the money/person buying Apple is no more or less clever or informed than the money that’s invested in Microsoft.

And so we follow the money.

The case for market capitalisation weighting

Extrapolating this logic to the whole market means we should own shares in all the market’s stocks, weighted according to their fraction of the overall value of the market.

Let’s assume for a moment that ‘the market’ refers only to the US stock market, and that right now Apple shares represent 3.5% of the total US market value.

This implies that 3.5% of our US equity holdings should be in Apple shares.

If we do anything other than this, then we are effectively saying that we are cleverer or more informed than we really are – that we have an edge over the other investors in the market.

But we don’t believe that’s true.

So 3.5% in Apple it is.

Follow the global money trail

Buying hundreds of shares in a stock market in proportion to their overall market capitalizations is much simpler today than it was even a generation ago.

It is pretty much what most index tracking products offer, assuming they are so-called market capitalisation trackers. (There are other sorts of trackers, which I believe we should reject as rational investors. I’ll explain more in a future article).

In our example above, Apple would constitute 3.5% of the value of a US index tracker.

But why stop at the US market?

There is no reason to think that the UK market is any less informed or efficient than the US one, for instance.

So if there is $15 trillion dollars invested in the US stock market and $2 trillion invested in the UK market, that’s what our portfolio should mirror if we’re to track each dollar, pound, or euro of global capital.

Likewise with any other market in the world investors can get access to.

We should invest in them all, in proportion to their share of the world equity markets, as best we can in practical terms.

No home advantage

Some of you may be nervously twitching at this point. You know you’ve got a lot more money in the UK stock market than in other markets around the world.

This is illogical for rational investors, although it is not unusual.

Many investors around the world overweight their ‘home’ equities.

For instance, the UK represents less than 3% of the world equity markets, but the proportion of UK equities in a typical UK investor’s portfolio is often 40% or more.

Why does this happen?

Investors feel they know and understand their home market. And perhaps active investors think they would be better able to spot opportunities before the wider market at home. (A fanciful notion for us rational investors!)

In fairness, the concentration in home equities can also be because of investment restrictions or perhaps because investors wrongly are matching their investment with liabilities connected to the local market.

Another factor that’s cited is currency risk.

While I think there is some merit in currency matching specific and perhaps shorter-term liabilities via your investment portfolio, I think such matching is better done through the purchase of government bonds in your home currency.

If you worry that major currencies fluctuate too much for you, then I would ask if you’re taking too much equity market risk in the first place?

Broader investment and currency exposure is in my view favourable not only from an additional diversifying perspective, but also as a protection against bad things happening in your home country.

Typically whenever a currency has been an outlier against a broad basket of currencies, it has been a poorly performing one because of problems in that country (though there are exceptions to this rule of thumb).

And it is exactly in those cases that the protection of diversified geographic exposure is of greatest benefit to you.1

Whatever the reason, various studies have suggested that this supposed home field investment portfolio advantage is not real, but many of us still continue to allow our portfolios to be dominated by our home market.

If you are overweight or underweight one country compared to its fraction of the world equity markets, then you are effectively saying that a dollar invested in the underweight country is less clever/informed than a dollar invested in the country that you allocate more to.

You would therefore be claiming to see an advantage from allocating differently from how the multi-trillion dollar international financial markets have allocated.

But you are not in a position to do that unless you have edge.

And we agreed we don’t have edge…

Since the millions of investors who make up the global markets have already moved capital between various international markets efficiently, the international equity portfolio is the best one for anyone without edge.

That’s on top of the other advantages of added diversification, simplicity, and cost.

Do you know better than all the world’s other investors?

Take me as an example. As a Danish citizen who has lived in the US and UK for more than 20 years, I might instinctively over-allocate to the US and Europe because I am more familiar with those markets than, say, Thailand or Japan.

But in doing that I would implicitly be claiming that Europe and the US would have a better risk/return profile than the rest of the world.

It might or might not turn out that way, but the point is that we rational investors don’t know ahead of time.

Similarly, you’ll often hear investors say things like: “I believe Brazil, Russia, India, and China are set to dominate growth over the next decades and are cheap”.

Perhaps you’d be right to say so, but you would also be saying that you know something the rest of the world has not yet discovered.

This is not possible unless you have edge.

Rational investors who accept they don’t have edge should therefore simply buy the global equity market.

The advantage of diversification

The world equity portfolio is the most diversified equity portfolio we can find.

And the benefits of diversification are great.

Consider the following chart showing how diversification impacts risk in a home market, such as the UK stock market:

portfolio-risk-versus-holdings

As you can see from the chart, the additional risk reducing benefit of diversification tails off as we add ever more securities to a home market portfolio.

This makes sense. Shares trading in the same market will tend to correlate, since they are exposed to the same economy, legal system, and so on.

This means that after picking a relatively small number, you have diversified away a great deal of the market risk of holding any individual company.

But by further expanding our portfolio beyond the home market we can achieve much greater diversification in our investments.

This is not just because we spread our investments over a larger number of stocks, but more importantly because those stocks are based in different geographies and economies.2

So we could have similar chart to the one above, but one where “securities” was replaced with “countries” in the x-axis.

Only a few decades ago, we did not have the opportunity to invest easily across the world like this.

But with the range of index funds and ETFs now available, investing in a geographically diversified way is a lot easier than it used to be.

One fund to do it all

In fact today you can invest across the global equity market by putting your all your equity money into a single world equity tracking fund or ETF.

To summarize the benefits:

  • Your portfolio will be as diversified as possible and each dollar invested in the market is presumed equally clever; consistent with what a rational investor believes. (I bet a lot of Japanese investors wished they had diversified geographically after their domestic market declined as much as 75% from its peak during the past 20 years.)
  • Since we are simply buying ‘the market’ as broadly as we can, it’s a very simple portfolio to construct and thus very cheap to run – and of course we don’t have to pay anyone to be smart about beating the market. Over time this cost benefit can make a huge difference. Don’t ignore it!
  • This kind of broad based portfolio is now available to most investors, whereas only a couple of decades ago it was not. (Most people then thought ‘the market’ meant only their domestic market.)

Even if you are already an index tracking investor, for some of you getting an internationally diversified portfolio may have involved combining multiple products in a bit of an ad hoc way to gain international exposure (perhaps based on gut feel of which markets will outperform).

Don’t bother. The market has already done all the work of allocating between countries and regions for you.

Instead, focus only on how much you want in equities overall compared to less risky asset classes and on collecting the equity premium.

The bottom line is you should buy the broadest based index tracking products you can.

By definition, that’s a total world equity market tracker.

Lars Kroijer’s book Investing Demystified is available from Amazon. He is donating all his profits from his book to medical research. He also wrote Confessions of a Hedge Fund Manager.

  1. Currency hedged investment products do exist, but in my view their on-going hedging expense adds significant costs without clear benefits, and on occasion further fails to provide an accurate hedge. Besides, many companies have hedging programs themselves meaning that a market may already be partially protected against currency moves, or have natural hedges via ownership of assets or operations that trade in foreign currency (like Petrobras owning oil trading in USD). []
  2. I believe this is still true, despite international correlations having gone up as the world has become more inter-related and large companies increasingly global. []

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{ 118 comments… add one }
  • 101 Tim G March 24, 2015, 11:00 am

    @The Investor ” an imminent article on this subject is headed Monevator’s way”

    Excellent. Look forward to reading it!

    @Lars “talk in London…”

    Could you give some more details?

  • 102 Bell_rife March 29, 2015, 11:02 am

    Hi Lars,

    I would very much like to attend such a talk.

    I live in the north but would travel to London to attend..

    Some thoughts:

    – Please announce the date as far in advance as possible, so that time off work can be booked, if it is not on a weekend

    – Can the talk details be announced on the Monevator blog so that the details of it are easy to find

    Thanks,

  • 103 Gregory April 14, 2015, 11:29 am

    Is there any real TER?
    Look the Vanguard FTSE All-World UCITS ETF. In 2013 and 2014 the fund outperformed the Index. See the Key Investor Information Document: past performance.https://www.vanguard.co.uk/adviser/adv/detail/etf/overview?portId=9505&assetCode=EQUITY##overview

    And an “old” article about:
    http://www.ft.com/intl/cms/s/0/90cea80e-9b8d-11e2-a820-00144feabdc0.html#axzz3RA6V09Nm

  • 104 Marco July 26, 2015, 9:16 pm

    I am totally sold on this idea. I only wish I’d come across an article like this when I started investing.

    This is so right for my goals that I have basically sold my entire equity portfolio and put the proceeds into VWRL.

  • 105 Nick March 10, 2016, 10:55 am

    Great article and sums things up very succinctly.

    One thing that sprang to mind, when investing with a relatively strong currency (GBP, USD) would there be even greater benefit to tracking “world” markets?

  • 106 The Investor March 10, 2016, 11:12 am

    @Nick — Cheers. Well as you know, when, say, the British pound is very strong compared to the US dollar, a £ buys you more dollar assets. Roughly half of a world tracker is in the US, so at such times of £ strength your £ would buy you more units of the tracker (or the ETF price would be lower than otherwise in £ terms). After you’ve invested, the value of the tracker (and any $ dividends you’re paid or that are reinvested) will continue to fluctuate as the £/$ rate fluctuates, which is currency risk in action. And of course your exposure to other countries’ currencies via owning the world tracker will follow the same path.

    See this article for more: http://monevator.com/currency-risk-fund-denomination/

  • 107 andrei July 12, 2016, 6:27 pm

    I’ve currently got and drip feed the following etf’s in my Fidelity SIPP. I plan to reduce the % of the non VWRL funds into VWRL when the U.S is cheaper, eventually ending up with 90% VWRL & 10% Gilts

    15% Vanguard VWRL
    15% Vanguard VUKE
    15% iShares EuroStoxx 50
    15% iShares Japan
    15% Vanguard VFEM
    15% iShares Pacific ex Japan
    10% iShares Gilts 0-5

    is this a flawed plan? How does the quarterly re-balancing work?
    if say, over the next few years, non U.S stocks out-perform the U.S will my existing block of VWRL move it’s allocation from 50% U.S to the other countries that are doing better? or is it just new purchases that are at the new percentages?

    I really like the idea of having all my equity allocation in one fund, but don’t want to be in the situation where 50% of my investment underperforms & I’m drip feeding 50% of my new cash into it every month.

  • 108 Graham Funnell February 10, 2017, 10:15 pm

    Powerful arguments. But wouldn’t a global small-cap tracker be a useful diversifier giving a different view of the market.

  • 109 Marco November 24, 2017, 10:51 am

    I’ve wondered about this Graham.
    My thinking is that for people who are invested 100% in equities, then global small cap is useful.
    However, if you hold bonds in your portfolio you might as well just increase your all world holding and reduce your bonds/cash.

  • 110 Chris December 5, 2017, 2:39 pm

    Guys – I’ve read Lars’ book and this thread. I must admit I am very taken by the idea of a single simple global tracker fund which aims to yield the index average. I’ve read so many people’s view’s and blogs and everyone has an opinion on active vs passive vs providers vs assets mix vs……. All of which implies they have an edge/view – which is inevitably different to everyone else’s. So the conclusion I have come to is that the majority of people actually don’t know anymore than I do (I’m not an expert by the way). So for what it’s worth here’s my view:-

    I’m about to retire and have decided on a draw-down approach. I therefore need to put my pot of DC fund somewhere. After countless hours of reading and talking to anyone who wanted to I’ve decided to go with Lars’ simple approach implemented as a bucket model – i.e. 3 buckets/pots/assets:-

    1 – A Global tracker
    2- A Bond/Gilt tracker
    3- A Cash fund.

    The mix is obviously down to your own risk tolerance but I’ll keep about 5 years of living in cash. I’ll then draw money from the Cash fund every year and rebalance.

    That’s it! Job done!

    Chris

    BTW on the discussion of US allocation in global funds has anyone looked at the Vanguard Global VHYL tracker? It seems a bit lighter in the US – 35%.

  • 111 Malcolm Beaton December 5, 2017, 6:33 pm

    Hi Chris
    Been on this road for some years now
    Down to 3 funds plus cash float
    There weren’t any World Index Trackers then so I have a Vanguard FTSE Index Tracker(4%)-a Vanguard World Index Tracker ex UK(26%) and my Gilts are all exchanged for a Vanguard Global Bond Index Fund Hedged to the pound(66%) plus Cash(4%)
    Been through 2002,2008 without any problems
    Very cheap to run-18 Basis Points(0.18%)
    Got a life ,sleep at night and drawdown from appropriate fund as required-rebalancing Portfolio at the same time
    Works for me
    Malcolm

  • 112 Jon May 12, 2018, 1:10 am

    Lars,

    You seem to be fixated on cutting costs. You should be more focused on proper asset allocation.

    The disparity between the returns of equities in one part of the world and another can be 30%+ in any given year.

    Your strategy has too little allocation to UK companies. By putting all your equities money into an ‘all world’ or ‘global’ index fund you will get about 6% in companies listed in the UK and 94% overseas.

    Using a UK all-share index alongside a global index will ensure more UK exposure than the average company listed in the rest of the world has (e.g. those in US index, the Europe index, the Japan index, the Emerging Markets index etc). This would be better for the average UK consumer (who lives their life in the UK and anticipates spending pounds in the UK in retirement) – has some ‘home bias’ ; while the All-World or Global All Cap equity fund products do not.

    That different asset allocation will result in a different level of gross return and volatility. If you lived outside the UK and had no reason to ‘overweight’ the returns of companies with UK assets or revenues then you would probably prefer a global fund (though might well want to add to it, something from your own country, because people do like to bias their investments domestically).

    So, not including a UK all share index, but using one global equity index and one bond index will give you an inferior result, because you’ve changed the asset mix within the equities away from a UK bias.

    To summarise: yes you can save a few basis points on fees by building your own dirty portfolio with only two fund components instead of three. In doing so you will have different results and likely greater volatility due to the limited exposure to UK equities. If you are happy with doing that, and believe the results will be no less desirable, go right ahead and build it yourself to save your 0.05% to 0.1% a year in costs.

  • 113 Marco May 12, 2018, 3:09 pm

    You are just speculating and have missed the point of the article.

    I have no edge so I’m sticking with market weight

  • 114 eagleuk May 12, 2018, 9:28 pm

    The vanguard LS trackers are overweight in the uk .They have 22-25% of UK instead of 6 or 8 percent.

  • 115 Kevin Mc Dermott May 29, 2018, 9:33 am

    As a renter with no capital in property, would it be ok to use property fund(s) for the bonds part of my portfolio?

  • 116 Malcolm Beaton May 29, 2018, 11:45 am

    No-it is like buying a single company share-it is just another form of equity investment
    You are very exposed to a sudden downturns in the commercial property/ housing market just when you need the money
    Bonds should make less money than equities but are safer
    With Bonds the money is spread across many companies and governments
    Government bonds are very safe-Gilts(UK),US Treasury Bonds etc
    Companies issue Corporate Bonds-these are not nearly as safe as Govt Bonds and should be bought with great care-often as risky as Shares
    Good advice in Bonds in this website-get reading!!
    xxd09

  • 117 Graham Funnell July 4, 2018, 12:39 pm

    I still find myself coming back to this article. Digressing for a minute, at the moment there seems to be a big controversy in the media between growth or value equity investing. This doesn’t seem to be a classic active versus passive argument as there are indices such as the Russell group which provide Growth and Value indices that can be tracked. The history seems to show that total return for growth and value indices changes year by year, on balance favouring value in the long term but not extensively so. Coming back to Lars’ article using a global tracker based on market capitalisation will ignore the growth/value issue. The particular blend of growth v value v blended will fall out of the index based on market size. At the moment this would buy a large investment in US FANG stocks which some people think are much overvalued and ripe for a year-2000 type-correction. What I can’t quite get my mind around is Lars’ assertion that buying the global market based on market cap automatically takes into account the ‘no edge’ approach in which we take the global index as reflecting the aggregate world view and that this is the best overall guide to use. Can anyone help me?

  • 118 The Investor July 4, 2018, 1:22 pm

    @Graham — It’s a long term approach. If/when you first invested in the global market tracker a few years ago, FANGs were at a much lower valuation. You’ve followed them up with a global tracker. In the meantime value shares have done nothing. If FANGs reverse here, well, you also own all those value stocks that (may) mean revert.

    If you’re saying you know that FANGs are overvalued then you are claiming Edge, which is fair enough (if unlikely) in which case choosing how to track a market is the least of your ways to try to make money. 🙂

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