From Project Syndicate by Jeffrey Frankel:
Some prominent institutional bond investors are shifting their focus from traditional benchmark indices, which weight countries’ debt issues by market capitalization, toward GDP-weighted indices. PIMCO, one of the world’s largest fixed-income investment firms, and the Government Pension Fund of Norway, one of the largest sovereign wealth funds, have both recently made moves in this direction. But there is a risk that some investors could lose sight of the purposes of a benchmark index.
The benchmark exists to represent the views of the median investor. For many investors – both those who recognize their relative lack of sophistication and those who don’t – going with the benchmark is a good guideline. This is an implication of the efficient markets hypothesis (EMH), for example.
To be sure, EMH theorists are often too quick to discount the possibility of beating the benchmark: It should not have been so hard to figure out during the 2003-2007 credit-fed boom that countries with high foreign-denominated debt, particularly in Europe, were not paying a sufficiently high return to compensate for risk. Or, to take another (harder) call, some of these same countries’ deeply discounted bonds, after heavy markdowns, would have been good buys in early 2012.
Nonetheless, most investors do better with a more passive investment strategy, especially given high management fees and excessive turnover for actively managed funds. A benchmark index gives that option to those who do not think that they can systematically beat the median investor, and provides an objective standard by which investors can judge the performance of active portfolio managers who claim that they can. Moreover, the same weights used in the index can be used to compute an average interest rate or sovereign spread in the market, which can, in turn, serve as an indicator of investors’ appetite for risk.
Finally, a benchmark index helps active investors to devise a deliberate strategy to depart from the median investor’s view when they believe that view to be mistaken. They may think that the median investor is underestimating risk in general or underestimating the downside in countries that have some particular characteristic. For example, they may conclude that a country has too much short-term debt, foreign-currency debt, or bank debt, or inadequate reserves or national saving.
For each of these purposes that a benchmark index serves, the correct way to weight different countries is by market capitalization, not by GDP. The keeper of the index must judge which countries and bonds are in “the market” – that is, are fully investable; but that is true regardless of how countries are weighted.