Some pension executives are adopting broader international indexes to cope with emerging market volatility and avoid diversification shrinkage resulting from the European Monetary Union.
Pension executives are adopting the broader indexes, believing the older indexes no longer make sense for them. But using broader indexes results in profound changes in how their funds are invested.
Typically, many pension funds have allocated assets -- using fixed percentages -- between the MSCI EAFE index for developed markets and the MSCI Emerging Market Free index.
But partly because of changes in European and Asian markets, the California State Teachers' Retirement System, the Washington State Investment Board and others are turning to the MSCI All Country World Index ex-U.S. free index -- or a similar broader international index such as the Salomon Smith Barney Broad Market Equity index.
And instead of fixed percentages, they are relying on market-capitalization weightings to allocate assets between developed and emerging markets. Pension funds also are grabbing a higher percentage of smaller-cap stocks using a broader index and adding Canada into the international mix.
Using a broader index removes the ticklish problem of how to handle emerging-market instability and resolves the issue of Euro bloc countries shrinking the diversity of EAFE.
The ACWI ex-U.S. free index, with a market capitalization of $8.1 trillion and 46 countries (the EAFE has a $7.1 trillion capitalization and 20 countries), includes emerging markets and Canada as well as the developed markets in EAFE. EAFE excludes emerging markets and Canada. Some 92% of the market value of ACWI ex-US free index is in developed markets: 65% is in Europe, 23% in the Pacific Basin and 4% in Canada.
The $88 billion CalSTRS, Sacramento, adopted the ACWI ex-U.S. index early this month. The $35 billion Washington state board, Olympia, adopted it in May, although the board is still realigning some of its international assets with the index.
Barclays Global Investors, San Francisco, launched its BGI All Country World Index ex-U.S. fund at the end of last year. The fund had $20 million in investments then, but has $2 billion now.
"The growth has been phenomenal. It is a hundredfold increase in assets," Rob Ginis, a director with BGI, said about the ACWI ex-U.S. fund. The fund's new clients are equally divided among corporate and public funds, large and small.
EXCLUDE HOME MARKET
Foreign pension funds are becoming interested in their own versions of the index, he said, which would exclude their home markets rather than the United States. BGI is setting up a passive index fund similar to the ACWI ex-U.S. for a Dutch pension fund now. Mr. Ginis declined to name the fund.
Over the past three to six months, Mark Sladkus, a principal with Morgan Stanley Capital International Inc., New York, said he has seen a spurt in pension funds, some of them large, adopting the ACWI ex-U.S. He thinks the trend will continue.
Aside from CalSTRS, three of Pension Consulting Alliance's other pension clients have adopted the ACWI ex-U.S., said Allan Emkin, a principal with PCA, Studio City, Calif. He did not name them.
Frank Russell Co., Tacoma, Wash., is sometimes recommending a Salomon Brothers Smith Barney Inc. broad market index, said John Osborn, a Russell consultant.
There has been a "surge of interest" among pension funds in Salomon's Broad Market index since the emerging markets crisis, said Tom Nadbielny, director of the Equity Index Group at Salomon Smith Barney, New York.
The differences in the ways pension funds will invest using broader indexes such as the ACWI ex-U.S. -- instead of a combination of the MSCI EAFE and EMF -- can be striking.
Pension funds that already have invested in emerging markets face pouring more money into a market that has alarmed many investors. For the year ended June 30, MSCI EMF scored a return of -39.1%, leaving pension funds to rebalance their portfolios into an asset class that is showing extreme volatility.
REBALANCING A PROBLEM
In theory, pension funds are supposed to bravely rebalance into plummeting asset classes. But some have been reconsidering.
"A lot of people have been grappling with this fixed weight to emerging markets and whether to rebalance to their target weight, and that is one very compelling reason that the ACWI benchmark makes a lot of sense as a strategic benchmark as well as an implementation benchmark," BGI's Mr. Ginis said.
Funding of volatile market segments can seem "counter-intuitive," said a PCA white paper on international markets.
Another problem with repeatedly rebalancing an EMF allocation is the high cost of emerging market transactions.
But with the adoption of the ACWI ex-U.S. -- a market capitalization-weighted index -- pension funds avoid both the rebalancing and transaction cost problems connected with emerging markets.
CalSTRS had a 5% target allocation to the MSCI EMF and 20% to the EAFE. That meant a target allocation of $4.4 billion into volatile emerging markets. But under its new weighting system, CalSTRS' emerging market target allocation is a little less than $2 billion.
At the time CalSTRS' original emerging markets allocation decision was made in mid-1997, emerging markets represented 20% of non-U.S. equity assets.
But since the emerging markets debacle, those markets represent only 8% of non-U.S. equity assets. Consequently, the proper allocation to emerging markets under the ACWI ex-U.S. is the market-cap weighted 8%.
But while CalSTRS' target allocation to emerging markets is less for now, the fund won't necessarily be pulling back from emerging markets in the long run.
Emerging markets could again grow to 20% -- or more -- of non-U.S. equity assets as weights rise and fall over time within the non-U.S. equity markets.
But by using a broader index, pension fund executives wouldn't have to rebalance or incur transaction costs with the expected growth in emerging markets.
THE MARKET DECIDES
With a broader index, pension fund boards no longer decide the proper target allocation to emerging markets because the market itself decides the amounts.
Use of broader indexes also removes pension fund worries about the market capitalization dominance of EMU countries and those closely correlated with them in market growth or declines.
The capitalization of the EMU countries presents a problem for pension funds similar to that of Japan in the late 1980s, when that country represented more than 60% of the EAFE index's value. Japan now represents about 20% of the EAFE's value.
The EMU bloc countries represent just less than 40% of the EAFE's value. Countries "highly correlated" with EMU represent another 35%, Mr. Ginis said. "Now (that) you have this huge trading bloc soon to be trading in the same currency, the same kinds of questions are coming from investors. 'Am I getting the correct amount of diversification?' "
Concern about the EMU's weighting in the EAFE is one of the driving forces behind investor adoption of the ACWI ex-U.S. Because it includes Canada and emerging markets, the index diversifies developed market investments, Mr. Ginis said.