NEW YORK -- Morgan Stanley Capital International may change the way it weights companies in its indexes, a move with huge consequences for institutional investors.
By the end of this year, the indexer will decide whether to continue basing its stock weightings on a company's total capitalization or switch to considering only the equity available to the public, known as free float.
If all of the investors using the MSCI indexes had to change the weightings of all the stocks in their portfolios, enormous upheavals in the markets could result.
"It would be the largest program trade in history," said competitor Thomas S. Nadbielny, managing director and head of the global equity index group at Salomon Smith Barney Inc.
For example, he said, only 30% of German telecommunications company Deutsche Telekom's stock is freely traded, while the rest is owned by the government. But the stock is weighted in the MSCI's Europe Australasia Far East and All Country World (ex-U.S.) indexes as if all DT stock were available to investors.
Rabbe Ekholm, chief mar keting officer for MSCI in the United States, said: "We have so much money benchmarked against our indexes, in the real world it (changing to free-float weightings) would be hard to do; it could have a big impact."
Rumors worry Asians
Rumors already are creating concern in some parts of the world.
A report that MSCI was going to make changes next month in the weightings of stocks in its Asian indexes worried investors in Hong Kong and Singapore, who were calmed by a statement by an MSCI official that the firm was studying the issue and had not yet come to a decision.
MSCI is considering the changes because of pressure from competitors, primarily FTSE International and Salomon Smith Barney, both of which use free-float weightings.
With about $2 trillion pegged against MSCI indexes, a major shift in the way they are calculated could cause major rebalancings and changes in stock prices, said Binu George, principal and international equity strategist at Barclays Global Investors, San Francisco.
Roughly $100 billion is benchmarked to the SSB international indexes; about $2.5 trillion is benchmarked to FTSE's indexes, but little of that is in the United States.
The free-float discussion "is a timely and important debate," Mr. Ekholm said. "We are approaching this seriously. I don't know what we'll do."
Selling in Germany, France
Jonathan Cohen, a portfolio manager at Northern Trust Quantitative Advisors, Chicago, which manages $1.6 billion in passive international assets, said the preliminary analysis he's seen indicates if the indexes were adjusted for free float, it would cause selling of stocks in Germany and France, which tend to be overweighted in the indexes, and buying of stocks in the United Kingdom.
Peter Kuntz, managing director at Deutsche Asset Management, New York, which has a total of $15.4 billion in international accounts for U.S. tax-exempt clients, welcomes the discussion about free float: "There's a recognition by vendors that there is a distortion that needs to be looked at."
Will Oulton, president of FTSE's U.S. operations, said that in its recently revamped All World index, FTSE has solved the free-float problem by "banding," meaning that if a company's float weighting is from 1% to 10%, its weighting in the index reflects 10% of its total market capitalization. If its float weighting is between 10% and 25%, it is weighted at 25% in the index, and so on.
With banding, Mr. Oulton explained, "We don't make any unnecessary changes to the index. We only make changes if they're significant -- if a company's float changes by plus or minus 5% around the band."
If free float is moved around very much, he said, "the cost to the user (of the index) increases."
The banding is being introduced over 18 months to lessen the market impact. The biggest changes will be for companies in Japan, Germany and Italy, where there are many crossholdings, he said.
Wooing U.S. investors
The FTSE index includes just more than 2,500 stocks vs. 2,192 stocks in the MSCI ACWI index.
While MSCI is used by the vast majority of international investors around the world, FTSE and Salomon are mounting major campaigns to win the attention and the business of international investors, primarily U.S. pension funds.
FTSE recently announced a strategic alliance with Frank Russell Co., Tacoma, Wash., through which the two will jointly market each other's products, including the recently revamped All World index and the Russell 3000, 2000 and 1000 indexes.
"The alliance with Russell will help get FTSE more use" in the United States, Mr. Oulton said.
One big reason MSCI has such a broad following is traditional -- the indexes have been around for 30 years, and for many years they were the only ones available for international benchmarking.
"If you were examining it from a clean slate, MSCI does have deficiencies," said BGI's Mr. George, who considers the lack of free float one of the main problems.
However, he said, because MSCI is dominant, transaction costs involving its indexes are about half those of trades involving stocks in other indexes.
As for the free-float problem, he said, FTSE's banding system is "smoother" than Salomon's system of having every stock included at its free-float weighting in the index.
MSCI does have a big advantage because it has become so entrenched in the investment world.
"We use the MSCI because that's the one most people are familiar with," said Steven Kornrumpf, director of the $70 billion New Jersey Division of Investment, Trenton.
"Our investible universe would be closer to the Salomon index," he said, "but at the moment we're sticking with MSCI because of the familiarity with it. However, we have looked at other indexes and may consider them in the future."
Free-float was among the issues that led the $35.8 billion Virginia Retirement System, Richmond, a month ago to pick the Salomon Broad Market index Global ex-U.S. to measure its entire international portfolio.
It also uses the Salomon Primary Market index, which is the equivalent of EAFE, to measure its developed countries core managers; and the Salomon Extended Market index to measure its developed market small-cap managers.
"As an investor we went through the absolutes that were important to us in a benchmark and the one that satisfied the most of them was Salomon," said Safa Muhtaseb, Virginia's investment officer.
The $12.8 billion San Francisco City & County Employees' Retirement System uses EAFE for its broad international holdings, but the Salomon Extended Market index, which includes 3,250 companies in developed countries, to measure international small-cap.
Fund officials have thought about changing to a float-weighted index, said Carl Wilburg, head of equity investments for the fund, but "we've got historical returns for the (EAFE) portfolio going back a long way. It's hard to scrap that even though we realize it's not as appropriate as it should be."
Easing investors in
Salomon is trying to ease investors into its indexes by offering, along with BGI, the Salomon Large-cap International Completion Equity index, or SLICE, for investors who want greater market coverage but don't want to leave EAFE.
Steven Schoenfeld, head of international equities at BGI, said SLICE "takes what's not in EAFE, but is in Salomon. If EAFE covers 60% of the market universe, SLICE adds about another 30% coverage."
However, Mr. Nadbielny said, Salomon is not encouraging broad use of SLICE because it wants investors to switch to the use of the whole indexes: "It's a transition step, a stepping stone on the way to using a full-float weighting of our indexes."