NEW YORK -- Morgan Stanley Capital International's proposed changes in its benchmark indexes could cause upheaval in equity markets, even if they are made gradually, conclude new reports by Goldman Sachs and Merrill Lynch.
New York-based MSCI is considering changing to free-float weightings of its global market indexes, an effort that would lead to large-scale changes in their composition. In particular it is considering increasing the market coverage of its indexes from 60% of the full market capitalization of every sector within each individual market, to 80% coverage based on a free-float basis. The free float of a company is the percentage of its shares that are deemed to be available for purchase on the market, an important determinant of a company's degree of investibility (Pensions & Investments, July 24).
The specific changes and plans for implementation will be announced by the end of this year.
Binu George, a principal and international equity strategist at Barclays Global Investors, San Francisco, which runs international index funds that use the MSCI indexes as their benchmark, said the proposed changes in the indexes "are critical and will explode in importance over the next year."
The proposed changes could boost portfolio turnover because about $4 trillion of assets is benchmarked to the various MSCI indexes. About $180 billion is indexed to the MSCI Europe Australasia Far East index and another $150 billion indexed to the MSCI World index, according to the Merrill Lynch & Co. report, written by equity derivatives strategist Diane M. Garnick, and co-workers Silvio Lotufo, Steve S. Kim and John Davi.
"Just the float adjustment is likely to result in 11% turnover for the MSCI Europe, Australasia and Far East, and 25% turnover for the MSCI Emerging Markets Free (indexes). The coverage expansion should raise turnover even higher," according to the Merrill Lynch report.
"MSCI has proposed doing it in phases, but doing it in phases is very complicated," said Sandy Rattray, vice president at Goldman Sachs Group Inc., London, who with research analyst Diana Gibson wrote the Goldman Sachs report. "To do one country at a time can give absurd country weights."
According to the Goldman Sachs report, "MSCI will likely find it hard to come up with an acceptable phasing process. They will need a simple solution that does not cause excessive total turnover and which does not distort country weights because some countries have been adjusted and others not."
Index switch suggested
This might be the perfect time for MSCI investors to weigh switching to another index, according to the Merrill Lynch report. An MSCI free-float shuffle -- whether it takes place gradually or all at once -- will cost investors money because they will have to adjust their portfolios to reflect the rebalanced index. Some, who might have avoided switching to another index because of the rebalancing cost, may see this as the time to do it because now, whether they switch or stay with MSCI, they'll still spend money rebalancing, the Merrill analysts wrote.
MSCI benchmark turnover linked only to free-float changes is expected to be 6% in the U.S., the U.K. and the World indexes; and near 30% for the EMF Latin America and EMF Europe and Middle East.
Other conclusions of the Merrill Lynch report include:
* Information technology and energy sectors stand to gain the most index weighting, while telecommunication and financial sectors will lose the most.
* In countries that already have high float and low cross-holdings, expanding coverage to 80% likely will add more smaller companies to the indexes. In general free-float weighting will result in MSCI covering a "larger proportion of a smaller universe" of companies.
* In expanding coverage to 80%, MSCI can use one of two methods: Only adjust undercovered countries upward to the 80% target, or do that and decrease coverage for overcovered countries down to 80%. The first scenario is more likely, the report authors said, because of the difficulty in scaling back over-represented countries.
* The U.S. weight within the MSCI World index is likely to rise between 4% and 5%, based on the United States' relatively high average free-float and its current low coverage.
MSCI has proposed using a "banding" approach to free float, to adjust the weightings of companies in its indexes based on 10 ranges, starting at 12.5% for a company with 10% free float up to 100% for a company with a 75% or greater free float.
Goldman's Mr. Rattray, in an interview, cited problems he foresees with phased implementation of the changes. For example, he said, Nippon Telephone & Telegraph Corp., Tokyo, is now in the MSCI indexes with a weighting based on 80% of its market capitalization, even though only 20% of the company's stock is available to outside investors. If MSCI were to use a phased-in approach, he said, instead of taking NTT's weighting down to the 25% band where it would officially belong, MSCI might initially drop it to the 50% band.
"It's extremely hard to explain," said Mr. Rattray. "Imagine being a fund manager having to explain it to pension plans."
U.K., Japan affected
Goldman's report points out that the biggest changes in country weighting that would result from adding new companies would be a large increase in the weighting of the United Kingdom and a large decrease in the weighting of Japan.
"We believe that MSCI ... is unlikely to adjust different countries at different times," the report states. "If, for example, MSCI decided to adjust the U.K. and Japan as a pair in the first phase, then the country weights of the U.K. and Japan would change significantly. They would then change again when the next set of countries is adjusted, causing more turnover."
Mr. Rattray said the difficulty of implementing the changes in phases leaves MSCI "with what they don't want to do -- do it in one go and have a big market impact."
"This will be a big event," he said. "People who create indices want to measure market performance, not create market performance."
This could "create a lot of market performance if it's badly handled," said Mr. Rattray.
He goes back to his example of NTT. "If its weight is taken down from 80% to 25%, there will be a lot of selling," he said.
Adding Shell Transport & Trading Co. PLC, a large London-based energy company, to the indexes, Mr. Rattray said, "would inevitably have a big impact on the index. Shell is the sixth biggest company in the U.K. (in terms of market capitalization) and it's not in the index now."
In regard to the EAFE index, Goldman's report also points out that "on an asset allocation basis, the level of turnover, at 13.5%, is significant under the MSCI proposed scenario. An indexer who only changed country asset allocation and did not alter stock weights would need to buy (13.5% divided by 2) and sell (13.5% divided by 2) of his or her portfolio. Worse, though, is the level of trading that an indexer who changed all stock weights would suffer" -- this amounts to buying and selling 23% divided by two.
Market impact concern
Rabbe Ekholm, executive director of MSCI, declined to discuss the comments on its proposals that MSCI is getting from outsiders.
But, he said, "the market impact is one of the considerations" MSCI will use when it determines if and when to make the proposed changes. "We want to have the least amount of market impact possible."
He acknowledged that money managers would have to incur both trading costs and costs of market impact. "There's no gain without some pain," said Mr. Ekholm. "We want to make sure the pain is not out of proportion with the gain."
Mr. Rattray said the announcement of the changes must come "before the last week of December. Dec. 15 is the last reasonable date. Once you get beyond that, you get into a lack of liquidity in the market." However, he said, the announcement could come Dec. 31 "because the market is more liquid on the first day of the new year."
Tom Nadbielny, managing director and head of global indexes at Salomon Smith Barney Inc., New York, said of competitor MSCI, "It looks like they've opened a Pandora's box. They've confirmed there is a problem with the indices and they're not quite sure how to fix it. The toothpaste is out of the tube and there's no clear solution for them."
He thinks that "just the news of what they're going to do" will have an impact on the markets. "I don't see how it can be helpful to the markets."
BGI's Mr. George said he hopes the changes are implemented "in at least two phases. I hope the advance notice will be longer. I talked to clients and (they say) we can't have a big bang."
Mr. George said the phases should be separated by six to nine months in order "to try to avoid front-running by hedge funds and brokerage firms."
"Rebalancing (the indexes) may have a substantial market impact because these are sizable companies and a sizable rebalancing would be necessary," said Kurt Toby, director of international investing at The Commonfund Group, Wilton, Conn.
Despite these concerns, he is in favor of the proposed changes because "the more representative of the real investment opportunities that one has, the better the index." He agrees that phasing in the changes would lessen the market impact.
The Merrill Lynch report noted that MSCI was the last of the major index providers to move toward comprehensive float adjustment. In addition, it noted the MSCI adjustments are additional steps toward convergence among global benchmarks. As a result, buyers should benefit from higher competition among index providers.