LONDON -- A new index of global multinational companies could shake pension fund asset allocations around the world.
The new index -- being developed by British consultant Bacon & Woodrow, index fund manager Barclays Global Investors and FTSE International, London -- likely will result in multinational companies being treated by investors as a separate asset class.
The asset allocation implications are dramatic:
* Pension funds could create multinational company portfolios as a separate asset class, hiring specialist passive or active managers. Allocations to a shrunken local index would be reduced.
* The proportion of multinationals stripped out of local indexes would vary by country. In Great Britain, with a high level of multinational representation, that could result in 40% to 45% of domestic equities being shifted into a new category, according to research by Bacon & Woodrow and BGI. In the United States, the figure is closer to 20%.
* The remaining local stocks would be more tied to domestic economics, and thus more closely linked to pension fund liabilities.
* A local index is more likely to be smaller in average market capitalization and have different sector weightings.
Meanwhile, BARRA Inc. officials are researching whether truly global companies can be broken out into a separate group, although more as a tool for portfolio managers. "The answer is yes," said Andrew Rudd, chairman and chief executive officer of the Berkeley, Calif.-based consulting firm.
Even if multinationals are not segregated, he said, money managers could make better asset allocation decisions. For example, they could pick stocks that better reflect country effects, and recognize global influences on many stock prices.
The upshot for pension funds is that multinational companies -- regardless of their domiciles -- could be carved out into a separate asset class.
"It's inevitable that the investment management profession will push in that direction," said Gary Brinson, chief executive officer and chief investment officer, UBS Brinson, Chicago.
The developments reflect increasing globalization, making many companies' legal domiciles less relevant to their financial outlook and stock prices. Only 12% of the Morgan Stanley Capital International World index consisted of global stocks 10 years ago, compared with nearly 28% now, explained Matthew Annable, managing director, active equity strategies, at BGI in London.
The research by Bacon & Woodrow and BGI addresses growing concerns that national indexes no long reflect local economic practices and that pension funds are hewing to arbitrary stock weightings.
For example, a British pension fund might hug the benchmark weight for BP Amoco PLC -- now worth 6% of the Financial Times-Stock Exchange All-Share index -- even though the company is multinational and reports its revenue in U.S. dollars, said Nick Fitzpatrick, head of Bacon & Woodrow's investment consulting practice. At the same time, the fund might not own any shares in Exxon Corp., a similar stock, he said.
"The way U.K. pension funds are constructing their portfolios has become disconnected with reality," Mr. Fitzpatrick said.
Genesis of research
Other issues also spurred the research. A year ago, the aborted merger of SmithKline Beecham PLC and Glaxo Wellcome raised concerns by some U.K. pension clients that they would have to put too much money into one stock.
With the merged stock accounting for about 8% of the FTSE All-Share index, that meant the typical U.K. pension fund might have had 4% of assets in the one stock.
That trend is creating "stock-specific risk," Mr. Fitzpatrick said, although BGI officials are less concerned with concentration than with arbitrary weighting of domestically domiciled multinationals vs. foreign-based ones.
In addition, more non-British companies have been shifting their stock listings to the London Stock Exchange, distorting the index's reflection of the U.K. economy. Recent converts include such South African companies as South African Breweries, Anglo-American Corp. of South Africa Ltd. and Old Mutual Life PLC.
Also, mergers between British and foreign companies are changing the index's complexion.
For pension funds, these issues raise the question of whether they were maintaining arbitrary weightings toward some stocks simply because of where they were domiciled.
Basing research on the MSCI indexes, BGI researchers stripped out all companies for which overseas sales make up at least 50% of total sales. They then narrowed the field to the top quarter of those stocks, filtering out smaller companies. The result was a universe of about 220 stocks.
Testing revealed the resulting asset classes -- multinational stocks and residual local indexes -- were more homogeneous, but not greatly so. Correlations among the various indexes decreased slightly, but not to an extent that was statistically significant, explained Kevin Coldiron, BGI's head of European research.
The results are "interesting but not yet compelling," Mr. Annable said. But the lack of a strong trend could reflect that people are used to investing on the basis of country and not globally. "It's a chicken-and-egg thing," he said.
The multinational index closely tracked the U.K. index over the 10-year period ended December 1998, lagging the U.S. a bit, but was the best from a risk-return basis. Mr. Coldiron said that the strong performance of global stocks could reflect a temporary bias toward them. The multinational index also has been somewhat less volatile than country-based asset classes, he noted.
Sector weightings in both the multinational and local indexes would be vastly different. For multinational companies, consumer goods and general industrials would each make up one-third of the index, with another 15% in resources, 13% services and 6% financials. There would be no weightings in utilities or investment trusts.
Compare that with the change for U.K. pension funds, which would switch from the FTSE All-Share to a more local index: Financials would surge to 34% from 24%, services would soar to 38% from 31% and utilities would climb to 10% from 6%. Meanwhile, the proportion of consumer goods, general industrials and resource stocks would plunge.
The extent of multinational stocks' influence varies enormously by country. For example, stripping out global multinational companies -- so-called to avoid any confusion over a company's domicile -- would affect only 20% of the U.S. market capitalization. But carving out multinational stocks would pull out 49% of Dutch market capitalization, 55% of Swiss market capitalization, 26% of German market cap, but only 8% of Japanese market cap, BGI officials found.
The right allocation of multinational stocks and local stocks would vary by pension fund. Bacon & Woodrow officials are conducting more research on asset/liability relationships.
Bacon & Woodrow and BGI officials emphasize their research does not represent a final product, but only a starting point. Many more complex issues of index construction remain to be resolved, which is why they brought in FTSE International.
"There needs to be more work done in defining these multinational companies," explained Mark Makepeace, managing director of FTSE International, London.
For example, researchers said they need to examine whether to base the definition on other factors than global sales, such as geographic diversity, earnings and number of employees.
Also, researchers need to explore how to handle the newly created Euro zone. For example, a Belgian company that racks up 50% of its sales in France now would be deemed a multinational company, Mr. Makepeace said. A more regional approach might make more sense.
In addition, some researchers worry it will be hard to develop one multinational index to suit all tastes. While U.K. pension funds rely on FTSE indexes, U.S. pension funds use a combination of the Standard & Poor's 500 index and MSCI international indexes.
There are other hurdles. Pension funds in some countries also have to deal with regulatory constraints, such as maximums on how much they can invest internationally. Even U.K. pension funds face a problem with the new minimum funding requirement, which refers only to the FTSE All-Share index and not international indexes.
All the same, the concept of spinning out multinational companies is generating tremendous excitement among investment professionals.
Mr. Brinson foresees a carve-out of large-cap global multinationals, combined with allocations to midcap and small-cap stocks defined by geographical borders.
Bruce Clarke, president of PanAgora Asset Management, Boston, said the influence of multinational stocks "has been an important point for several years."
But research by PanAgora executives has found most big multinationals behave more like local stocks, either because their investor base is local or they are captured in local indexes, he said.