Correct the inherent risk of the Australian share market...
... and better capture the opportunities
This week we take a moment to consider the Australian market in the context of the wider global equity market.
Below you can see a comparison of the composition of the ASX All Ordinaries Index, and the MSCI World Index  (the global equivalent of the All Ords) as at 31 Dec 2016, by industry type.
A number of points will easily leap out at readers.
Firstly, relative to the rest of the world the Australian market is very top heavy in Financial stocks (e.g. the banks) and Materials' stocks (e.g. BHP, Rio, etc). Real Estate is also relatively large. In fact these three sectors together represent 60% of the Australian market. This makes the ASX very exposed to global events, either through commodity prices or global monetary policies.
Secondly, Australia is very underweight Information Technology with IT representing only 2% of the local market, compared with 16% of global markets.
Thirdly, all other sectors are within reasonable bounds (+/-10%) of the wider global marketplace.
Notwithstanding a couple of big skews, most global sectors are reasonably well represented to Australian investors today. With the benefit of franking credits and an ability to understand and research companies more thoroughly, the urgency to chase financial returns by investing overseas (apart from benefiting from currency diversification) may not be as strong today as some are being led (or aggressively marketed) to believe.
But that is a separate story.
On the positive side, these weightings show that provided one is prepared to risk adjust (i.e. reduce your exposure to banks/resources & property and not over pay for growth stocks) then it is still possible to build a well-diversified portfolio in Australia today.
On the negative side, it also shows that the “average” Australian investor has (largely unwittingly) become overly exposed to leveraged businesses (i.e. financials and resources) and underexposed on growth (as seen in its low IT share). Because of this inherent risk this imbalance needs to be corrected by intentional action.
The intentional action that investors should take for a more diversified share portfolio is to invest in more growth oriented businesses and less in financial businesses.
This action, however, runs counter to the common Australian practice of building a portfolio based on Australian market weights. This practice means over-weighting (in a global portfolio sense) financials and materials companies just because they are big in Australia.
The corollary is under-weighting smaller or medium sized companies that would fill the growth gap.
I'm not saying that the MSCI World Index has ideal sector weights. The large weight of 19% to Financial stocks is perhaps an over representation of sensible exposure to that sector (exaggerated in Australia by a further 20%). But it is significantly better diversified than the ASX.
This is shown by the median sector weight for the MSCI being 10%, but only 7% for the ASX.
The MSCI World Index is also hamstrung by its bias, obviously, toward country size.
The size bias is obviously a risk with any capitalisation index.
But my point is not to argue the merits of a capitalisation weighted index. It is to draw attention to the relative weakness of using ASX capitalisation weights as a starting point for portfolio management.
It is a poor starting point.
 MSCI World Index (originally the Morgan Stanley Capital International Index) is a broad global equity benchmark that represents large and mid-cap equity performance across 23 developed markets' countries. It covers approximately 85% of the free float-adjusted market capitalization in each country.