CAMBRIDGE, Mass. - New England Pension Consultants has issued a blanket recommendation that its 156 clients switch to Salomon Smith Barney indexes as their international equity benchmarks. Two other consultants have made similar recommendations for some of their clients.
"We decided to revisit the international indexes that were available, given the changes to their indexes that MSCI announced in December," said Joseph Breitfelder, a senior partner at NEPC, Cambridge. Mr. Breitfelder was referring to Morgan Stanley Capital International's plan to change the way it weights its global benchmark indexes to reflect only the free-float, or portions of companies' stock that is available to investors. "We felt Salomon had the better product."
NEPC's clients have about $19 billion invested in international equities.
At the same time, BARRA Rogers-Casey, Stamford, Conn., is recommending the Salomon indexes, which are already free-float weighted, to clients "who are using a complex international structure," said Roger Fenningdorf, a partner in the firm.
And Frank Russell Co., Tacoma, Wash., is recommending that consulting clients "with active international mandates should seriously consider moving to the Salomon indexes," said Greg Nordquist, senior consultant. However, Russell is not recommending that clients with passive international mandates switch from MSCI's Europe Australasia Far East index, because it "has the lion's share" of passive international accounts benchmarked to it, said Mr. Nordquist, and it would cost more for clients to use a different benchmark. Russell also recommends that clients with both passive and active international investments stick with EAFE because it isn't good to use two different benchmarks for active and passive investing, said Mr. Nordquist.
Rob Fishman, the NEPC senior analyst who did the research on the indexes, said Salomon's international growth and value indexes are better than those of MSCI, because while MSCI uses the price-to-book ratios of stocks to determine whether to classify them as growth or value, Salomon uses three growth and four value factors to determine the makeup of its indexes.
And, Mr. Fishman said, with the changes taking place in the MSCI indexes over the next 18 months, "there's going to be some turmoil, and why put up with that?"
The Salomon growth and value indexes topped the EAFE index over the three-, five- and 10-year periods ended Dec. 31. Because growth and value styles perform well at different times, it is particularly noteworthy that both styles of Salomon indexes outperformed EAFE, Mr. Breitfelder said.
In his research paper, Mr. Fishman said, "managers that run EAFE index portfolios will feel the brunt of the changes to the MSCI index. They will be forced to sell out of countries that have their weighting reduced, and buy into countries whose weighting will increase. Worse, they will have to compete with other passive managers seeking to make the same trades. Conversely, active managers, hedge funds and brokers have the most to gain. There is at present enough information on available float for active managers to determine which securities will have their weightings increased and which securities will have their weightings decreased. This will allow for increased arbitrage opportunities and the ability to significantly outperform the EAFE index."
Passive investors will face increased trading costs and lower returns, he wrote, while active investors will benefit from being able to "front run" the changes.
The Broad Market index, the basis for all of Salomon's global indexes, "is one of the most comprehensive global equity indices available, and (it) allows for the creation of other `component' indices that focus on (capitalization) size, global, international or country-specific, developed markets to emerging markets or growth vs. value," Mr. Fishman said.
The BMI includes 49 countries, 8,700 companies and $23 trillion in available capitalization.
NEPC considered including the indexes of FTSE Inc., London, in its recommendations but had reservations about FTSE's banding approach, in which a company's float weighting is rounded up to the nearest of several "bands."
"The tradeoff with FTSE's approach is to make the index more cost efficient due to lower turnover, while sacrificing a level of investibility," said Mr. Fishman in his report.
With the banding approach, if a stock has a free float of 21%, its weighting by FTSE would be rounded up to 30%, or 1.43 times its investible equity.
Also, "FTSE doesn't offer value and growth indexes," he said.
Jane Staunton, president of FTSE Americas Inc., New York, takes exception to Mr. Fishman's assertions on investibility. Unlike Salomon, she said, FTSE uses liquidity screens that "look at the dollar value of stocks that trade over time and the dollar volume traded. If a stock has 90% free float but doesn't trade often, it's less investible."
Rabbe Eckholm, executive director of MSCI in New York, said the arguments used by NEPC "echo the Salomon argument" about why investors should switch to its indexes.
Mr. Eckholm also said that for people who don't want to wait to switch to the revised EAFE, MSCI will have a "provisional index" available as of June 30 that reflects the changes to be made in the MSCI indexes.
This index will "run parallel" to the current MSCI indexes and will represent the reconfigured index, which will be in place in 18 months. "It will be the actual index, not an approximation or test of it," said Mr. Eckholm. Investors "can go ahead and benchmark against that index."
"You would be better off waiting until June than moving to an index you might not want over the long term," he said.
BARRA's Mr. Fenningdorf said he prefers the Salomon indexes for certain complex international portfolios because "there's no overlap and there's no misfit between the growth and value indexes and the small-cap index."
In MSCI's small-cap and large-cap indexes, he said, "there's an overlap between the small-cap benchmark and EAFE. There's no overlap between the Salomon small-cap index and the Primary Market index."
All three firms' benchmark indexes are fine for pension funds that have only one or two international passive managers with all of the assets in large-cap mandates, said Mr. Fenningdorf.
San Diego switched
One of BARRA's clients already has decided to make the switch, albeit in a move that was not initiated by the consultant. The San Diego County Employees' Retirement Association was to switch its international equity investments to SSB's benchmarks effective March 31. The $3.8 billion fund has 25% of its assets invested in international equities. Michael Munson, assistant chief investment officer of the fund, said, "We saw that Salomon was already float weighted and we preferred to switch earlier rather than later."
The $28 billion Pennsylvania State Employees' Retirement System, Harrisburg, on March 14 adopted the Broad Market index as the benchmark for its large-cap international stock mandates. It hired State Street Global Advisors, Boston, to run $750 million in international regional and country strategies benchmarked to SSB's indexes. BARRA is the fund's consultant.