HSBC Global Asset Management sees the need for an alternative benchmark allocation for equities and government bonds different from the conventional approach of allocating to each country in proportion to the size of its financial markets.

The asset manager says that country allocation, which it sees as one of the most important decisions that investors have to make, based on market capitalisation is only the preferred choice if global financial markets are efficient and in a stable equilibrium. "Both experience and academic research suggest that this is not the case: markets are too volatile and investor behaviour is too far from the rational information processing ideal," says Adam Olive, senior investment strategist. "Because of this, alternative asset allocations should generate higher returns with less risk than the conventional benchmark allocation."

As diversified portfolios of securities are fundamentally predicated on the current and future output of the world economy, a long-term benchmark allocation for an international portfolio should be based on the distribution of economic output across countries, according to HSBC. And because the appropriate measure of output differs for equity and bond investors, this alternative approach will be different for the two asset classes.

Writing in a quarterly investment update, Olive says that gross domestic product is not suitable for generating a baseline allocation for equity investors, as equities represent claims on the economic output of publicly-listed companies and GDP is a measure of total output. Instead, the firm has estimated a figure based only on output by public companies for the developed and the major emerging market countries, and then used these "GDPs" and purchasing power parity foreign exchange rates to calculate baseline allocations for international stocks.

Applying this method on a $100 portfolio would decrease US holdings from around 43 per cent using the traditional approach to 35 per cent, while increasing emerging market positions from 14 to 20 per cent.

Moreover, HSBC argues that GDP is an appropriate measure of government bond allocation as it effectively represents claims on the entire economic output of a country. This approach would cut exposure to Japan from 29 to 9 per cent of a $100 portfolio, and increase emerging market exposure from around 9 to 25 per cent.

HSBC believes the suggested alternative asset allocation benchmarks would outperform traditional market capitalisation-weighted benchmarks over time.