What are the advantages of GDP weighting?
Toloui: In addition to embedding a forward-looking orientation in the index construction, GDP weighting can also help avoid some of the crucial pitfalls of traditional market capitalization-weighted indices. The market capitalization approach increases the weight of securities that have recently gone up in price and reduces the weight of securities that have recently declined in price – exactly the opposite of the investment maxim to “buy low, sell high.” Moreover, market capitalization weighting in a bond index can allocate too heavily to government debt and large bond issuers with debt burdens that might be negative for creditworthiness. The current crisis offers a case in point: With their fiscal deficits on the rise, G-7 governments will be issuing large quantities of bonds over the next few years. This will lead to an increased allocation to G-7 government bonds in traditional market cap-weighted indices. GDP-weighting avoids this adverse tendency, relative to traditional indices.
